Look for the small cap ‘stars’: NovaPort Capital

Small cap stocks are anything but ‘average’ so investors need to look beyond the the ASX Small Ordinaries Index and actively manage their small cap portfolios, or risk missing out on significant opportunities, according to boutique small-cap fund manager NovaPort Capital.

In a research paper released this week – ‘Concentrating on Small Companies’ –  NovaPort found the performance of small companies over the past decade varied greatly – 38% suffering share price declines while conversely one in ten of the remaining 62% delivered a share price increase of over 1,000 per cent.

“What the analysis shows us is few small companies have delivered an ‘average’ return. In fact, a lot of them have been relatively disappointing investments. Over the last 10 years, for every company which exceeded our return criteria, there were two which lost money,” NovaPort Portfolio Manager Sinclair Currie said.

NovaPort believes its analysis demonstrates the ASX Small Ordinaries Index is a poor representation of the real growth opportunities, and confirms active management is essential to capture the true investment potential of small companies.

“It’s essential investors focus on a few good ideas rather than hug the index to realise the real potential for returns and growth in the sector,” Mr Currie said. “Small cap investing is very different to large cap investing. It covers a broad classification of businesses linked by only one common factor – size, making active management even more important.”

The S&P Indices Versus Active (SPIVA®) Index, which measures performance of actively managed funds against their relevant index benchmarks, reinforces this argument.

The 2013 mid-year SPIVA® scorecard indicates that over two-thirds (68 per cent) of Australian equity active funds were outperformed by the ASX 200 over a three year period, while the vast majority (82 per cent) of active small cap funds outperformed the ASX Small Ordinaries Index.

Significant number of “golden opportunities” for strong, stable growth

Despite the difficulties in picking winners, NovaPort Portfolio Manager Alex Milton remains upbeat about the meaningful number of small cap opportunities that provide for stable growth in the longer term.

“There are a significant number of companies who deliver returns in excess of our hurdle rate of  around 15 per cent per annum or 50 per cent over three years. Investors who overlook small caps are passing up a golden opportunity for strong portfolio growth,” Mr Milton added.

“Successful small caps investing is about a few good ideas. We invest in small caps to find ‘shooting stars’, companies that will grow to become the next big thing, not stay in the index for years,” Mr Milton concluded.

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The research based on NovaPort’s proprietary methodology, based on analyst consensus estimates of valuations for 2015 earnings, separates the Australian small cap sector into six different categories.
 
According to NovaPort, almost two thirds of the small cap sector (by capitalisation, 61.3%) sits in the high or moderate growth category – that is being relatively profitable and expected to generate growth in the coming years. Based on 2015 projections, NovaPort’s research shows these two categories are currently trading between a 17 to 20% discount to ASX leaders.

High growth small cap companies, which make up over one third of the small cap (34.6%) sector, are dominated by stocks from the financial and resources sector, the latter representing just under half of the total companies.
 
“The companies in the high growth category are established, profitable and are expected to grow earnings in excess of 10% per annum. We seek to identify small caps that are exposed to new and expanding markets, have strong management teams and can feasibly grow market share based on innovation,” NovaPort Capital Portfolio Manager Sinclair Currie said.
 
“We see plenty of scope for small companies within the high growth group to generate even higher rates of growth, as investor interest continues to pick up in the small cap sector,” Mr Currie said.

Not all mining and energy small caps will show growth 
Mining and energy small caps are expected to dominate the cream of the crop as well as the laggards in the index.
 
Small companies in the mining and energy sector are equally spread across the six different categories identified by NovaPort, but were differently affected by the current economic conditions.
 
While mining and energy companies are strongly represented in the high growth small cap category, they also account for an equally high proportion of the low growth and speculative categories. The biggest risk factors to these small cap underperformers are depressed commodity prices and uncertainty around project viability and financing. This is also impacting listed mining services businesses as analysts factor in slowing resource capex into their current estimates.
 
However, NovaPort remained upbeat about the sector’s opportunities, and identified Horizon Oil (ASX: HZN) and Independence Group (ASX:IGO) among mining and energy small caps in the top 18% of the sector.
 
“We view Independence Group as an attractive stock and over the next three years we expect the Tropicana Mine, of which they own 30%, to ramp up production and deliver a major lift in earnings if their costs and gold output forecasts can be achieved,” Mr Currie said.

Mr Currie downplayed the effect of commodity prices on mining small caps, saying the earnings growth was also driven by each company’s ability to develop new projects on time, within budget and at the forecast production parameters.
 
NovaPort was a finalist in the 2013 Morningstar Awards for Australian equities small caps. NovaPort was awarded the Australian Equities (Small Cap) and Rising Star awards at the Money Management / Lonsec Fund Manager of the Year Awards in 2012.

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