Michelle Innis looks at whether small caps can sustain high returns.
Managed funds that invest in small companies can be a bit like meteors: they can blaze brightly but burn out quickly. Small cap returns have been spectacular but with a few exceptions it is doubtful whether they can be sustained.
Results for the year to October 31 show that the 10 "worst" performing small cap funds achieved returns in the order of 15 per cent to 27 per cent.
Those at the top of the class had a stellar year: returns ranged from 62.59 per cent for Equity Trustees' Small Companies Fund to 30.05 per cent for the BT Classic Smaller Companies Fund.
"In the good times, people adjust their risk/reward ratios," says John Morgan, the head of Australian equities at ING. "In good times, small cap funds tend to do well."
As their name implies, such funds invest in small listed companies. Some invest in companies outside the Australian Stock Exchange (ASX) Top 100 or ASX Top 200 (measured by market capitalisation), while others look for companies with a market capitalisation of less than, say, $250 million.
Some funds invest in Australian and New Zealand companies, and one, the Equity Trustees' Small Companies Fund, can invest in small companies before they list.
The Equity Trustees fund returned a staggering 62.59 per cent over the year to October 31. It also put in a decent performance in the year prior, recording a return of 36.75 per cent, according to Anthony Pesutto, an investment analyst at Lonsdale Securities.
"We recommended this fund in November last year," Pesutto says. Lonsdale rates the fund manager, Melbourne-based boutique asset management firm SG Hiscock and Co, highly. It manages the money invested in the Equity Trustees small cap fund, while Equity Trustees presents the fund to the retail investor.
Pesutto says Hiscock manages it with a "well-defined investment process". It is able to capture market sentiment, especially risk of earnings upgrades or downgrades; it has strong sell signals if stocks are underperforming, and good review processes.
Media-shy SG Hiscock (which declined to comment) has a high level of staff ownership of the firm, ensuring stability of fund managers.
The bad news for some is that the retail fund, now at $50 million in funds under management, closed to new investors last month.
The total fund size, including wholesale money, is close to $350 million. The fund has a stated target of $450 million, above which point management feels it would lose its nimbleness in investment markets.
Closing the fund off at $350 million allows existing investors to add to their holding, and it provides room for capital growth within the fund itself.
Pesutto says the performance of small cap funds tends to be driven by the manager's ability to pick the right stocks. "No one stock tends to dominate the market as it might with larger companies," he says.
But the small end of the market is also leveraged to expectations that the broader economy is picking up.
"Small cap stocks are generally less liquid, but when the market is buoyant, more people look to second-tier stocks," says Glebe Asset Management's portfolio manager, Brad Ware. "They tend to be less risk-averse because times are good, and they tend to think more about the fact that some small companies are leaders in their own space."
Glebe, an ethical investor, has a Small Cap equities trust that returned 41.20 per cent in the year to October 31, but 4.32 per cent over three years.
ING's Small Companies Growth fund and Emerging Companies fund had positive results in the year to October 31, but negative returns for the three years to that date.
For example, the ING Small Companies Growth fund returned 21.26 per cent over the year to October 31, but -9.14 per cent over three years.
ING's Morgan says: "The small cap end of the market tends to be more volatile than the broader sharemarket. It can be subject to a more volatile earnings stream."
But Challenger Financial Services' portfolio manager, James Ring, disputes this. The Challenger Small Companies (retail) fund returned 49.30 per cent in the year to October 31 and has a three-year annual average return of 32.4 per cent, Ring says.
"It is true that the 1990s belonged to the top 100 companies," Ring says.
"Small companies were a neglected asset class, and that has changed over the past year. But you can't make generalisations about the environment [suiting or not suiting small caps]."
Ring says the attractiveness of large companies globally has been reduced dramatically, and smaller companies are appealing on a valuation basis.
"The second point is that there are some great stories emerging from small cap land," he says. "This is occurring for a number of reasons."
Ring says increased merger and acquisition activity has resulted in more large companies and fewer medium-sized enterprises.
"Just look at the finance sector," he says. "We have a few very big companies and then a raft of small, boutique operators. That structure goes for a number of industries. When we look for companies to invest in, we look for a growth profile.
"There are fewer middle-tier companies providing competition and stopping those small companies from growing. When we look to buy a company, we look for that company to have room to move, to grow."
Most analysts in the small cap area also say that smaller companies are frequently more accessible to analysts and open about their management style.
"We take each company case by case," Ring says. "We can do intensive due diligence. You can't really predict the future, but I see bigger issues for the big companies and where they go from here.
"It is easier to see where a small company can go and how much it can grow than a $10 billion company."
