Small companies offer big opportunities in 2010

As we move through 2010 and beyond, investors with the ability to select stocks via a more concentrated approach to their portfolio are likely to generate higher long-term returns. The next decade will probably be one of slower growth amid deleveraging, which will favour growth stocks. At such times, investors tend to look for stocks where earnings are growing faster than the overall economy, and they are often willing to pay a premium for them.

In this type of environment, small companies can offer attractive opportunities to buy emerging leaders in new markets or back an entrepreneurial manager who can expand the business’ market share. While investing in small companies has long been regarded as a higher risk strategy, small businesses are known for being innovative and helping to pull the economy out of recessions. Even if they have limited access to the credit markets, they are typically able to find investors who are looking for good ideas in which to put money to work.What has history taught us?In an analysis of small company share price performance for the last 10 years, we found that 22 per cent of companies delivered a compound annual return in excess of 20 per cent per annum. A select 3 per cent of companies delivered a spectacular return of over 50 per cent per annum. However, the potential downside of investing in small companies was also clearly evident, with almost 40 per cent of the companies we looked at posting negative returns over the last 10 years.

Successful investing in small companies is as much about avoiding the 40 per cent of stocks posting negative returns as it is picking the winners.

Resources have driven the market

A closer analysis of the distribution of stock returns reveals a clear theme — 17 of the top 20 stocks were from the resources sector. The S&P/ASX Small Industrials Index today trades at almost the same level as it did 10 years ago; in contrast, the S&P/ASX Small Resources index has more than quadrupled.

A major change over the last decade has been the massive run in commodity prices. Crude oil, copper, nickel, gold, coal and iron ore all fetch multiples of prevailing prices 10 years ago. The generally agreed explanation for higher prices has been explosive demand from emerging economies (in particular China) combined with a deficit of capacity due to decades of underinvestment.

Despite this overwhelmingly supportive thematic, there were plenty of resource stocks that posted negative returns over the last 10 years. Following the ‘theme’ alone did not help to avoid these.

In our experience, following some simple guidelines helps define the most successful small company investments. Below we highlight a few important factors to look for:

• a management team that displays a passion for the business and has a clear strategy to grow it;
• a company that provides its customers with a competitive overall offering;
• a company operating in a marketplace offering opportunities to expand the business; and
• often the best opportunities are those that have escaped the attention of the market, which can be preoccupied with chasing momentum in ‘themes’ or ‘hot’ stocks.

Gazing into the crystal ball

As investors, part of our job is to try and determine whether the outperforming stocks and sectors of the past decade will continue higher, or whether we should shift our attentions elsewhere.

Our contention is that the dynamics that have driven resource stocks to outperform so spectacularly over the last decade are now well understood by the market. This makes it more difficult to find undervalued stocks in this space. Furthermore, as each new project commences we move closer to oversupply, an outcome the market does not seem to discount.

Being wary of overexposure to the resources sector, we look at other companies and sectors left in its wake. As always, there are stock-specific examples of companies extending their market share through innovation and strategic acquisitions. Companies such as Iress Market Technology, David Jones and Reckon are examples of stocks that have rewarded investors without being obviously thematic.

There are also those companies exposed to growing markets driven by legislative, demographic and technology shifts. The healthcare sector will benefit from an ageing population, Internet-based business models benefit from technology penetration and innovation and the investment management industry is a beneficiary of a growing pool of savings due to compulsory superannuation.

Resource stocks and the resource-related theme has been the major driver of small company returns for the last decade, however, even super cycles by definition mature. We believe it is prudent to cast a wide net when looking for the best stocks to own in 2010. Some of the less passionately pursued themes and stocks appear relatively attractive to us at this point.

Small and large caps do have one thing in common now: investors are awaiting fourth-quarter earnings results and expecting to see growth for both revenue and profitability for the first time in over a year.

Sinclair Currie is senior portfolio manager, small caps at ING Investment Management.