Exploring the small/mid-cap frontier

small/mid caps Tim Hall Fairview stephen wood eiger capital Nick Cregan fairlight Robert Calnon OC Greg dean Cambridge

16 October 2020
| By Chris Dastoor |
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In the frontier of equities, small and mid caps are the untamed Wild West – they have great potential for riches and rewards but there are plenty of unknown risks and volatility for those unfamiliar with the landscape.

Small and mid-cap equities offer greater exposure to a wider variety of lesser-known growth companies, rather than concentrating on the smaller amount of major players.

Small caps have greater potential for growth as they are less mature than large caps, but the sparse yet abundant nature of opportunities means it is important to be able to pick and choose quality investments.

According to FE Analytics, within the Australian Core Strategies (ACS) universe, the global small/mid-cap sector returned 5.16%, while its Australian counterpart returned 4.2% over the year to 30 September, 2020.

In that same time period, the global and Australian equities sectors reported 3.45% returns and 6.63% losses, respectively.

Performance of Australian and global small/mid-cap sectors versus the broader equity counterparts over the past year to 30 September 2020

However, when looking at the past six months, Australian small/mid-caps returned 40.36%, followed by global small/mid-caps (19.85%), Australian equities (18.64%) and global equities (11.02%).

Tim Hall, Fairview portfolio manager, said small-caps were trading on a valuation discount, compared to the large-cap sector.

“According to the investment banks, small caps are presenting at least twice the levels of earnings growth of the big caps,” Hall said. 

“Within the small caps sector, the opportunity to tap into the long-standing thematic of digitisation and disruption is larger than many investors expect.”

VOLATILITY

While the sector reported outperformance, this came with increased volatility. 

Over the previous year to 30 September, 2020, out of the 37 sectors listed in the ACS universe, the Australian small/mid-cap sector was the fifth most volatile, with a volatility of 26.26 while the global small/mid-cap sector was the 11th most volatile (20.28).

As with any sector, Hall said small and mid caps were best utilised as part of an overall investment portfolio, given the higher volatility in returns.

“Stock selection is absolutely paramount in the small-cap space because the risk parameters are higher,” Hall said. “Knowing the risks and opportunities which exist in the sector, a sensible way for investors to access small caps is via active managers.”

However, Stephen Wood, Eiger Capital portfolio manager, said volatility was less of a factor if an investor invested in a fund with a sensible strategy.

“We’re of the view that if you do sensible things, you can get the risk of the portfolio down to a level where it is consistent with the ASX 100, let alone the ASX Small Ordinaries index.

“There’s more to small caps than just generating a bit of alpha or wealth creation; you have to be careful you don’t end up with something that’s a bucking bronco.”

DEFENSE

Although small caps had a reputation for growth, which subsequently came with the risk of volatility, it was still possible to approach the sector with a defensive mindset.

Nick Cregan, Fairlight Asset Management portfolio manager, said there were plenty of defensive opportunities in the space.

“Does that conflict with each other? Well yes, would be the answer,” Cregan said. “The market has, to a large degree, been very focused on growth assets – the growth end of the small-cap market.”

Cregan said he did not believe you needed to be “swinging for the fences” in order to generate a good return over and above the index.

“The reason for that is in our index there’s quite a few businesses that are very low quality and don’t make much money through the cycle,” Cregan said. “By avoiding that part of the market, you can harvest the small-cap premium without taking on undue risk.”

Even in the small-cap sectors, it was still possible to screen out firms that required a lot debt.

“That keeps us out of utilities and property trusts; we don’t like highly-cyclical businesses and that keeps us out of banks, oil, gas and mining, or businesses that fail our ESG [environmental, social and governance] screening,” Cregan said.

“We don’t like single points of failure, so biotech and unproven technologies are all screened out.

“The characteristics we’re looking for are high recurring revenues and customers that are locked into a business model.

“We typically find them in the consumer, media, light industrial, niche technology, and healthcare space.”

US AGAINST THE WORLD

As with equities, investors could choose between focusing at home, here in Australia, or having a broader investment base by looking globally.

Robert Calnon, OC senior investment analyst, said staying within Australia allowed a stricter focus on a defined range of equities.

“We have a team of four, we can travel around our market inside a day – we can be in either Brisbane or Perth for a day or half a day,” Calnon said. 

“If you’re a global team, you certainly can’t do it with a team of four, you’d probably need a team of 40 if you’re truly a global investor.

“But you’d have a spend a lot of days on a plane which is also impossible in a COVID environment.”

Calnon said it was less efficient to be in a global product versus a fund focused on the concentrated Australian small/mid-cap market.

“We can develop an edge, we can develop relationships with management, we can have a focus on the 100 stocks we look at, rather than maybe 5,000 stocks that you can be investing in global small caps,” Calnon said.

“There’s a cultural alignment speaking to Australian managers about an Australian business to Australian investors.

“Whereas if you’re a US fund and looking at a company in France and it’s run by a Brit… those conversations can be very different, as is the relationships you develop.”

Greg Dean, Cambridge Global Asset Management principal and portfolio manager, said there was strong adviser interest for global small caps.

“If you’re looking at it from the perspective of allocators, it’s no secret that fee budgets are under pressure,” Dean said.

“Global small caps are an area within global equities where people are really finding it hard to replicate or do it themselves.

“A lot of the internalisation of large-cap equity management is freeing out budget to invest in the more labour intensive but also potentially more opportunistic area which is global small caps.

“You need a team that’s staffed, resourced and experienced in order to exploit the opportunity so we’re seeing a lot of momentum for allocators who are growing.”

However, Wood said investing only in Australian small caps still allowed for global opportunities as there were global companies invested in the Australian Securities Exchange (ASX).

“Take some of the stocks that have really come through COVID-19 with completely transformed and enhanced business models like Corporate Travel, Redbubble, Marley Spoon – they’re all global businesses,” Wood said.

“Yes, it’s listed here, but what you get out of the Australian small/mid-cap space is that you get some traditional businesses… but it’s also going to include global small/mid-caps.

“Within the Australian space there are an awful lot of global opportunities.”

ACTIVE V INDEX

As with other equity sectors, there was also the choice between active management or simply following an index-tracking exchange traded fund (ETF) with both having their own advantages.

Dean said because of the apprehension due to volatility in the sector, choosing an active manager was the best way to secure higher returns.

“Not every business is a great business and [small caps] are 10 times the size of the large-cap universe,” Dean said.

“We have the benefit of being able to be selective, but active management means avoiding business that aren’t growing or aren’t run by smart, honest and capable people.

“Different to large companies, a couple of people can really make the difference between compounding above average and compounding at a negative number, and that’s where the risk does come in.

“We manage that risk by looking at businesses we understand, trying to evidence long-term track records, identify strong balance sheets and not overpaying for them.”

Hall said active management was necessary because of the sheer number of mispriced opportunities in the small-cap sector.

“We’ve witnessed over the last five years a 30% reduction in the number of analysts’ earnings estimates,” Hall said.

“But moreover, the analysts aren’t updating those numbers as regularly and certainly we saw during COVID-19, not only did companies pull guidance but there was also a couple of investment banks that pulled in analyst estimates because the outlook was so uncertain.

“That gives us an incredible opportunity because the premise of our investment process is around company contact.

“We’ll hold over 600 company management meetings on an annual basis, with the expressed intention of trying to identify or unearth insights that we can then use to understand which opportunities are mispriced.”

Thong Nguyen, BetaShares senior portfolio manager, said they agreed with active managers that passive investment could be inefficient in this context, but it was possible for passive funds to adapt.

“We agree with the active managers that there are better ways to gain exposure to small-cap stocks than by a passive exposure that aims to track the ASX Small Ords Index,” Nguyen said.

“This is because this segment of the market is inefficient and less researched than large-cap stocks; where we differ is in what that ‘better way’ is, and how to access small caps.”

“Small caps can be extremely risky and volatile, and many have business models that are yet to be proven over the long run and a big part of successful small-cap investing involves avoiding the losers.”

Small/mid-cap ETFs had the same advantages as other ETFs as they were an easy to buy, liquid asset.

Nguyen said their small-cap strategy, despite being a passive one, was still able to utilise screens to remove companies which could be a drag on long-term performance.

“These screens aim to identify companies with positive earnings and a strong ability to service debt,” Nguyen said. 

“Relative valuation metrics, price momentum and liquidity are also evaluated as part of the stock selection process. 

“The result is a tailored portfolio of typically between 50 and 100 small-cap stocks, which aims to outperform the Small Ords Index.”

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