Smaller Australian companies provide a different opportunity set for investors than larger companies.
Australia’s smaller companies
A company’s market capitalisation – the total number of its shares on issue multiplied by the latest share price – dictates which index (if any) a company is a constituent of. Companies with lower market capitalisations are known colloquially as small caps. There are 2,200[1] ASX-listed smaller companies stocks; however, just 200 companies comprise the S&P/ASX Small Ordinaries Index, which represents the small cap members of the S&P/ASX 300 Index.
When compared to the S&P/ASX 200 Index, typically used as the benchmark for Australian equity funds, there are some significant differences with respect to market capitalisation and concentration.
Another point of difference is the GICs sector breakdown between Australia’s largest and smaller companies (figure two).
Finally, as illustrated in figure three, the small cap market is more diversified and idiosyncratic when compared to indices focused on larger companies.
As a sub-index, the S&P/ASX Small Ordinaries Index changes regularly, with companies moving in or out; companies with increased market cap may move into the S&P/ASX 100 index. New constituents may enter from the ‘bottom’, also as a result of market cap growth. Companies that experience a diminishing market cap may be removed from the index to be replaced by another with a higher market cap.
Why invest in Australian small caps?
There are a number of factors that make small caps attractive. These include:
- Smaller companies are often under-researched by stock analysts and therefore potentially mispriced, presenting opportunities for astute investors to cherry pick the best opportunities.
- Investing in a small cap company in its early stages of development, staying invested while it expands and grows, can potentially provide substantial returns. All companies had to start somewhere – many of Australia’s top 50 stocks were once ‘small caps’.
- Smaller companies are often the target of merger and acquisition activity, which is generally positive for a company’s share price.
- It’s much easier for an ASX listed small company to double or triple in size than for an ASX blue chip to grow at the same rate (see figure four).
- Smaller companies tend to be nimbler and less bureaucratic, the benefit being increased agility and flexibility to adapt to changing market conditions. This can give them an edge over larger competitors.
- Greater diversity – as illustrated by figure two, the ASX-200 is dominated by financial and materials companies – small caps provide exposure to a more diverse range of industries. Some growth areas, such as communication services, consumer discretionary or information technology, have greater representation outside of the ASX-200.
Because a company is ‘small’ today doesn’t mean it will necessarily remain so. Small caps typically grow faster (earnings) and their asset pool appreciation (multiple expansion) is faster than the broader market; this provides the opportunity for enhanced returns (figure four).
Finally, one of the most compelling reasons to invest in smaller companies is that they are often at the forefront of innovation, providing investors with exposure to new trends and emerging themes. Small caps are often disruptors and in some cases, create entirely new markets.
With any investment opportunity comes risk. Small caps generally exhibit higher levels of risk because:
- Small companies are generally less liquid, with evolving business models and developing markets.
- Small companies may be more susceptible to changes in the economic environment. Instances such as a larger company pushing out its payment terms during tough times can starve a small company of vital cash flow and have a devastating impact.
- Smaller companies are often reliant on one product or service, particularly in its early days; a change in demand for that product or service can have a significant impact on the business, something that can be positive or negative.
- Smaller companies tend to trade less frequently than larger companies so can sometimes be harder to sell.
- It may be harder for small companies to access capital at a reasonable cost.
Many of these risks can be mitigated by experienced small cap managers.
The case for active management
When it comes to investing in small caps, the first thing to note is the vast amount of research required. While individuals can get access to a lot of information about Australia’s blue chip companies, all which have extensive broker coverage and detailed investor relations information online, information is scarcer with small companies. This research requires both time and access to information; the latter isn’t always as easy to come by, especially as smaller companies have significantly less broker coverage (figure five).
Investing successfully in small companies requires work to understand the individual industries, companies, and their respective management teams. Even in the initial stages of an investment, an in-person visit is important to get a feel for a company and understand what drives it, something not available to individual investors.
There is also a need for rigor and discipline when processing company information – including screening, modelling, and valuation – something best undertaken by investors with experience in understanding the nuances of a smaller company’s financial position and balance sheet. Ultimately, positive returns come from identifying the best while trying to avoid the worst.
The Australian market structure supports the concept of information arbitrage increasing as company size declines, which is also supportive of active management. The information arbitrage opportunities that are available to small cap investors can provide opportunities for experienced active managers with the skill set to sift through, and invest in, quality businesses.
At the same time, some of the risks associated with small cap investing need to be managed, which takes experience and a proven active process. These include:
- Execution risks, which tend to be elevated with smaller companies
- Earnings and share price volatility
- Understanding the evolution of business models and the potential for disruption.
These facts support the case for active investment; simply buying the small cap index may deliver higher volatility, greater portfolio risk and lower total returns.
As detailed at the beginning of the article, there are 2000+ companies listed in Australia, but for many professional managers, a large part of that universe that is uninvestable. Such uninvestable companies might include early stage start-ups, poor balance sheets with no obvious path to improvement, corporate governance concerns or those without a clear path to earnings and share growth. The key to this information is access to the management team, a key differentiator for active managers.
Case study: Life360
Location sharing and driving safety App Life360 Inc is a good example of the research process required for a small cap stock and the rewards that can accrue for investors.
Although based in San Francisco, Life360 founders Chris Hull and Alex Haro decided to look to the ASX to raise funds. The company listed on the ASX in May 2019 and while Tribeca’s small caps team determined it was too early to get involved in the IPO, the company was closely watched.
COVID-19 hit the share price hard. With nobody leaving home, there was no need for parents to be worried about the safety of their family. The app had not been particularly popular among the teenage children of the people who use it to keep track their offspring’s whereabouts, although Life360 did introduce some clever social media marketing campaigns to combat these issues.
Tribeca saw value in the company if Life360 could get the transition to a paid membership strategy to work, and, despite the impact of lockdowns, there were early signs of success. The management team was also looking to make strategic acquisitions to increase market penetration. Tribeca bought into the company just after COVID-19 hit in 2020, after which it has gone from strength to strength. Earlier this year the company bought Jiobit, a wearable tracker for pets and young children.
With the majority of Life360’s users in the US, impressive monthly user and subscriber growth is driving results. Management has been capitalising on the economic reopening and the back-to-school period with marketing campaigns that are improving customer conversion rates.
More recently, Life360 announced it has entered into a binding agreement to acquire Tile Inc for a total consideration of up to US$205 million. To fund this, it is conducting an equity raising through which it aims to raise A$280 million. The acquisition is expected to complete in the first quarter of 2022.
Tile Inc sells hardware devices that can be attached to items, such as wallets, keys, computers and so forth to help users find them. With Tile Inc, Life360 can offer the whole suite of location services from ‘things’ to family and pets.
Small Cap outlook 2022
The recent searing rally in yields should mollify momentarily, given the market has largely priced 12 months of rate hikes in the US already. This should allow for a rebound in the market, inclusive of tech and growth. Should the virus risk finally start to moderate as expected, we anticipate a normalisation of the consumption environment away from goods to experiences (Ooh Media, Corporate Travel, Tyro to be beneficiaries).
Sales lines over the past 24 months that benefitted from excess consumption will be hard to cycle. Discretionary stocks that can deliver growth independent of the economic environment and where valuations are reasonable (Universal Stores, City Chic) are likely to do well. While the growth environment remains favourable, we expect value will continue to outperform. Commodities are included in this, particularly where a lack of capex investment and/or new areas of demand have created deficits (Nickel Mines, IGO Ltd, Karoon). Together with some GARP names such as GUD Holdings and Eclipix Group, and growth exposures where valuations stack up (Life360, PWR Holdings), the outlook for small caps looks reasonably positive.
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