Smaller Australian companies provide a unique opportunity set for investors.
Despite the fact they often punch above their weight, smaller companies can be overlooked in an investment portfolio. This article from GSFM examines the small cap universe, the investment case for smaller companies and why active management in this sector is important.
Smaller companies (or small caps) have great potential and can often offer investors bigger opportunities than those usually found in the broader market. However, as an asset class, Australian small caps have, over recent times, experienced one of their worse periods of relative performance versus larger companies in the past two decades. Despite this period of poor relative performance, the case for investing in Australia’s small caps remains strong and as outlined later in this article, there are signs of a turnaround.
Australia’s small caps
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 2,230[1] ASX-listed smaller companies stocks; however, just 200 companies comprise the S&P/ASX Small Ordinaries Index (Small Ords), 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. As you can see, the top 10 stocks of the S&P/ASX 200 Index make up nearly half of the market weighting of that index; therefore, benchmark aware large cap Australian equity strategies are potentially exposed to concentration risk.
Another point of difference is the GICs sector breakdown between Australia’s largest and smaller companies (figure two).
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.
Why invest in Australian small caps?
There are a number of factors that make small caps attractive. These include:
- 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’. And in the global context, the world’s largest company Apple was once a constituent of the MSCI small cap index!
- Following on from that example, it’s much easier for a small cap to double or triple in size than for a larger blue chip to grow at the same rate.
- Smaller companies are often under-researched by stock analysts and therefore potentially mispriced, presenting opportunities for astute investors to cherry pick the best opportunities.
- Smaller companies are often the target of merger and acquisition activity, which is generally positive for a company’s share price.
- 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 consumer discretionary and 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 can provide an opportunity for enhanced returns.
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 market segments.
With any investment opportunity comes risk. Small caps generally exhibit higher levels of risk because:
- They are generally less liquid, with evolving business models and developing markets.
- They can 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.
- They are often reliant on one product or service, particularly in the 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.
- Volumes traded tend to be lower than for larger companies, so it can sometimes be harder to buy or sell a small cap holding.
- It may be harder for small companies to access capital at a reasonable cost, particularly in the current environment with interest rates pushing up the cost of capital.
Many of these risks can be mitigated by experienced small cap managers.
Small caps and the current environment
As an asset class, Australian small caps have experienced one of the worst periods of relative performance versus their large caps peers in the past two decades. This has been caused by three factors:
- The composition of the small cap index – with relative small cap overweights in sectors that have performed poorly and been affected by higher interest rates and tighter financial conditions. These include building materials, consumer discretionary, investment technology and real estate.
- Earnings revisions – revisions have been far more negative among small caps, particularly when compared to their larger cap peers. Many small caps have struggled to pass on input cost inflation; conversely large caps often operate in highly consolidated industries and possess stronger pricing power.
- Depreciating AUD – historically, small caps have underperformed during periods of a depreciating AUD. Large cap companies generally have more exposure to foreign currency denominated earnings, while small caps tend to be more domestically focused.
There are signs, however, that the outlook for small caps is becoming more positive. There are attractive opportunities appearing in some of the more beaten-down sectors where expectations are low, and where valuations are now comparably very attractive. With inflation starting to normalise and the AUD having potentially bottomed, small cap margins should start to improve.
The case for active management
When it comes to investing in small caps, the first thing to note is the substantial amount of research required. While individuals can get access to a lot of information about Australia’s blue chip companies, all of which have extensive broker coverage and detailed investor relations information online, information is not so readily available with small caps. While investment relations teams provide the facts, shallower analyst coverage means that much more research effort is required.
Investing successfully in small companies requires effort to understand the individual industries, companies, and their respective management teams. A good understanding of competitors, large and small, is also important. 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 winners 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.
In conclusion, investing in Australian small cap companies can provide investors with several benefits, including exposure to a diverse range of industries and potentially high returns. Small cap companies have the potential for rapid growth and can often outperform larger, more established companies in certain market conditions. Additionally, Australia’s stable political environment, robust financial regulatory system and strong economic fundamentals are supportive for the sector.
When recommending small cap funds, advisers must be aware that small caps can present a riskier investment due to their smaller size and potentially volatile nature. This is where a professional, active investment manager can add value.
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