Is it time for small cap stocks?

Co-founder of the Switzer Report
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Arguably, it has been ‘pretty easy’ earning top returns through share portfolios heavily weighted to the major banks, Telstra, Woolies, Wesfarmers etc. However, if we do start to see some real economic growth, smaller companies – the traditional drivers of growth – are more than likely to lead this market higher.

For the first time since the GFC, the planets seem to be aligning to suggest that you think hard about your exposure to small cap stocks. In fact, some of the smarties have already moved – with small cap stocks outperforming the broader market over the last couple of months.

Small caps – the laggards

Typically, ‘small cap’ stocks are defined as the stocks outside the ASX 100. The best proxy for the performance of this part of the market is the S&P/ASX Small Ordinaries Index (ASX Code XSO), which covers stock numbers 101 to 300 by market capitalisation. There are also another 1,800 stocks that don’t even make the top 300 (arguably, the micro-caps), but there is no index that covers this part of the market.

Until very recently, small caps (in aggregate) have been absolute dogs. As the following table shows, over 1 year, 3 years and 5 years, the Small Ordinaries (stocks 101 to 300) have massively underperformed compared to the top 20 (S&P ASX 20) or top 100 (S&P/ASX 100). Only in the last couple of months has this picture changed.

Australian Stocks – Total Return

The upswing in the performance of small caps since July is displayed in the following chart. This shows over the last 12 months daily index values for the S&P/ASX 100 Index in red (ASX Code XTO) compared to the Small Ordinaries Index in blue (ASX Code XSO), set to a common base.

ASX 100 vs. Small Ordinaries

Small caps vs. large caps

Small cap stocks come from very different industries to the major stocks, and hence have different growth and income characteristics. For example, the following pie charts show the sector weights as at 6 September of the Small Ordinaries compared to the broader S&P/ASX 300. Note the very big increase in weight for stocks from the consumer discretionary and industrial sectors.

 

Five reasons to buy small caps now

  1. A government more sympathetic to business, low interest rates and improving consumer confidence should be good, in particular, for the consumer discretionary sector.
  2. The Aussie dollar has depreciated by around 15% – and is set to fall further. This will be a positive for industrial stocks.
  3. The outlook for growth globally is improving, with 2014 likely to be a better year than 2013. This will favour ‘growth’ stocks, which are more typically represented in the smaller stocks. The market will “price this in” ahead of it actually occurring.
  4. The relative performance of the smaller stocks has been (on average) so staggeringly bad since the GFC, ‘mean reversion’ says that at some time, they have to come back to par.
  5. While there might be some tentative signs of credit growth, bank stocks will lag the broader market in a strong upswing. Basel III drives the need for more capital – ROEs (return on equity) on banks will fall.

And three reasons not to?

  1. Smaller stocks pay lower dividends. The ‘yield return’ on the stocks in the Small Ordinaries over the last 12 months has been 3.27% – the yield on the top 20 stocks has averaged 5.78%.
  2. Healthcare, which is arguably the sector with the best long-term demographic fundamentals, is under-represented.
  3. Smaller stocks are harder to follow – less public information, research and analyst commentary.

Bottom line? On a relative value basis, and given my positive outlook on the overall market, I think the “ayes” have it.

How much to invest – and how to do it?

The capitalisation of the Australian stock market is approximately $1.5 trillion. The top 100 stocks make up $1.15 trillion or 75% of this amount, leaving a weighting of 25% for the balance of the circa 2,000 listed companies. Some of these stocks are so small and illiquid that you would never want to touch them – so a 25% share (of your Australian equities weighting) would be a pretty material position.

Stock numbers 101 to 300 (the stocks that make up the Small Ordinaries) account for $110 billion or 7% of the total market’s capitalisation, so a weighting in small caps of 15% to 20% of my overall allocation to Australian equities would be about the amount I’d consider.

How to do it? Well, apart from building a portfolio of individual stocks, there are also three “managed” alternatives.

Firstly, if you’re interested in index management, invest through an Exchange Traded Fund. There are two small cap ETFs that both track the S&P/ASX Small Ordinaries Index. State Street’s SPDR S&P/ASX Small Ordinaries Fund (ASX Code SSO), which has management costs of 0.50% per annum, and Blackrock’s iShares S&P/ASX Small Ordinaries (ASX Code ISO). The latter’s management expense ratio is 0.55% per annum.

Active investment management options are listed investment companies (LICs) and managed funds. LICs to consider include Geoff Wilson’s WAM Capital Limited (ASX WAM) and WAM Research Ltd (WAX), Mirabooka Investments (MIR) and Emerging Leaders Investments Limited (ELJ). Some of these LICs have broader mandates than just ‘small caps’, so carefully review their product information.

And of course, there is a plethora of managed fund options. Funds to consider include Ironbark Karara Australian Small Companies Fund, Eley Griffiths Group Smaller Companies Fund and the Perpetual Wholesale Smaller Companies Fund.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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