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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van Eyk considered a total of 29 strategies in the review, awarding three strategies its top ‘AA’ rating. There were also eight ‘As’, nine ‘BBs’, and two ‘B’ ratings awarded. 

Five strategies were screened and two refused to be rated. 

Separating the best managers from the rest were a stricter attention to stock valuation, superior knowledge of the small sector and individual stocks and an intimate understanding of what causes a stock to re-rate, which is central to successful small caps investing. 

Lead analyst on the review Varun Venkatraman said it was a strong field. All the strategies reviewed outperformed the S&P/ASX Small Ordinaries index over a 1-5 year time frame. 

The AA-rated managers also all outperformed the S&P/ASX200 over the same time frame. 

“It’s a highly competitive peer group, much more so than the large cap sector” Mr Venkatraman said. “It reinforces our belief that over the long term there is good potential for these managers to generate excess returns for investors.” 

The ability of managers to identify quality companies was key to their rating but in the small caps sector this is particularly important given it is relatively under-researched by the market compared to the large cap sector. Managers that are able to definitively identify strong balance sheets, superior management and defendable earnings streams are more likely to outperform. 

“This also means that a manager has to have a very broad knowledge of the sector,” Mr Venkatraman said. “The composition of the small caps index changes relatively quickly and managers have to keep on top of who is in the investable universe.” 

Small cap managers often have a closer relationship with the management of a company whose stock they own not only because these companies tend to be more approachable than larger companies but also because it is frequently necessary to get enough information on the company.  

A rigorous approach to the valuation of stocks was also critical as well as a thorough knowledge of potential triggers for a company’s stock be re-rated by the market. “Finding companies that are undervalued and knowing what changes will likely lead to a price correction is an important skill in a successful small cap manager,” Mr Venkatraman said.

van Eyk has a bias towards small cap managers that are “benchmark unaware” given the potential for deriving excess returns from the sector. That is, the managers are not subject to strict stock and sector limits and are free to exploit investment opportunities to their fullest.

van Eyk also considers the level of funds under management important when rating a manager because managers must remain small enough to be able to quickly and easily take advantage of new investment opportunities.

Many managers believe that about one per cent of the Small Ords index is a suitable capacity limit. “We believe this may be somewhat on the high side,” Mr Venkatraman said. “We are more comfortable with 0.5%-0.7%.”

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Senior Investment Analyst Sam Morris commented, “Personnel changes have traditionally proved to be a persistent feature of the smaller cap universe, as talent looks to move if not sufficiently tied-in to overall business profitability or appropriately compensated.”

“In terms of the Lonsec peer group, approximately 50 percent of managers can be broadly classified as either an independent or boutique with the support of a cornerstone investor, such as Treasury Group, nabinvest or Challenger.”

There are a number of practical advantages in this business model.

“Key investment staff gain equity in the business, increasing alignment with investors and potentially their motivation for success,” said Morris.

“In addition, the investment team remains liberated to focus largely on investment functions, with things such as compliance, administration and distribution outsourced to the supporting backer.”

“Moreover, cornerstone investors provide much needed capital which brings stability in the early years of a new funds management business.”

Lonsec recognises that key person risk is a prevalent risk factor in many of the higher quality smaller companies products.

“Successful performance in this asset class is highly dependent upon the investment skill and experience of key individuals,” commented Morris.

“Nonetheless, Lonsec believes that key person risk is a risk worth taking and we recommend that consideration is given to the overall remuneration and incentive structure for key investment professionals.”

Smaller companies continued to struggle…yet fund managers restore faith in active management
The S&P/ASX Small Ordinaries Accumulation Index returned -23.4% in 2011, compared to the positive 13.1% gain in 2010. Despite this, the relative performance of small cap investment managers has been impressive, with the Lonsec Small Cap Peer Group outperforming the S&P/ASX Small Ordinaries Index by 8.3% over calendar 2011.

“This gives credence to the established view that the small companies universe is less efficient than the larger cap end, with few companies covered by brokers,” observed Morris.

“This enables professional investors to uncover attractive investment opportunities before being discovered by the wider market.”

As a result, Lonsec recommends active investment over passive strategies in this asset class.

“A well regarded small cap manager is likely to outperform the index through the cycle,” said Morris.

“Having said that, we are seeing more products coming to market offering beta exposure – although with such products, investors will be exposed to the full index – the good, the bad and the ugly.”

The perennial issue: how much is too much FUM?
Capacity is an issue that has long generated debate in the small cap sector. There is a divergence of views on the problems arising from too much funds under management – those managers with a large weight of money – such as BT, Perpetual and Acorn – are keen to talk down the negative aspects on the grounds that larger managers may:

• Enjoy greater access to company management
• Engender preferential treatment in IPOs or equity placements
• Influence company direction through substantial status.

On the other hand, smaller players place greater emphasis on the limitations of a hefty weight of money suggesting that larger managers are:

• Less nimble in the market
• Unable to access small company opportunities or exit large positions
• Inconvenienced by broader market awareness of substantial holdings.

“Generally, Lonsec believes capacity management is not a black and white issue – there are positives and negatives to low or high levels of FUM,” commented Morris.

“However on balance, we believe that managers with smaller FUM are better placed to add value and Lonsec’s higher rated managers will tend to be attractively positioned from a capacity perspective.”

The review
Lonsec’s Australian Equity Small Cap Sector Review encompassed 35 funds, of which seven attained Lonsec’s top rating of ‘Highly Recommended’. These included the Antares (Aviva Investors) Small Companies Fund, the Celeste Australian Small Companies Fund and the Perennial Value Smaller Companies Trust, all of which were upgraded as a result of this review.

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“The median manager in the group returned close to 5% per year, after fees, ahead of the ASX Small Ordinaries Index over the past three years. It highlights the success of active management within the sector,” said John Huynh, analyst at S&P Fund Services. 

There were 45 headline funds in the review cycle, which included micro-cap, mid-cap and traditional small-cap strategies. S&P upgraded seven funds and downgraded two. There were five new funds and three withdrawals. 

The Aviva Investors Professional Small Companies Fund was upgraded, and is the only five-star offering in the peer group. This reflects our very high conviction in the capabilities of the team and the effectiveness of its investment approach. A healthy track record, combined with a competitive fee structure, make the fund attractive to retail investors. Other funds that were upgraded include NovaPort’s Small Companies and Microcap funds, the Perennial Value Smaller Companies Trust, the Ironbark Karara Australian Small Companies Fund, the Ausbil Microcap Fund and the BT Midcap Fund. 

While there is just one five-star fund, quality across the peer group remains high, as shown by the number of four-star ratings. When rating high-quality strategies such as the BT Smaller Companies Fund, and the Eley Griffiths Group Small Companies Fund, our highest conviction was primarily tempered due to concerns about capacity, and the risks associated with managing large amounts of money within the sector.  

The Invesco Australian Smaller Companies fund was downgraded to four stars. While remaining a quality offering, our rating action reflects a number of factors including broader peer-relative assessment and an overall reduction in conviction. 

New funds rated in this review include the Glennon Capital Small Companies, Concord Discovery Fund, Grant Samuel Tribeca Australian Smaller Companies, OC Dynamic Equity and Premium Equity funds, and LSC Australian Resources Hi-Alpha.

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