Small-cap options – WAM and Mirrabooka

Financial journalist
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One noticeable aspect of the Australian stock market in recent times has been the under-performance of the small-cap stocks, those valued at between $20 million and $300 million. (In the US, the definition of a small-cap is a stock worth less than $US1 billion.)

The S&P/ASX All Ordinaries Accumulation Index (which counts capital gains plus dividends) gained 20.7% for the year to June 30. But its small-cap counterpart, the S&P/ASX Small Ordinaries Accumulation Index – which includes the stocks ranked 101 to 300 in the capitalisation ladder, lost 5.3% for the year.

The markets have been so volatile, and the headlines so full of gloomy economic and financial headlines, that investors have mainly sought the perceived safety of the large-cap stocks. A closely allied trend is the search for yield from equities, given the lower term deposit rates that now prevail – this also tends to favour the larger stocks. Effectively, the Top 20 Australian stocks lead the index.

This makes the Australian share market one of the most highly concentrated stock markets in the world. However, this means that it should be rewarding ground for small-cap investors, because of “information arbitrage” – learning more about a company than anyone else.

Leverage the information advantage

Institutional investors tend to concentrate their interest within the Top 50, let alone limiting it to the S&P/ASX 200. Given that there are almost 2,200 listed companies on the ASX, that means a lot of companies don’t get much interest from broking analysts and fund managers.

However, small-cap investing is a specialised field. Small companies usually have fewer offshore operations and are more leveraged to the domestic economy. They are also a bellwether for risk appetite.

Markets are still very skittish, worried about global economic growth, particularly in China, and the potential effects of the end of cheap money presaged by recent Federal Reserve comments about a schedule of “tapering,” or starting to wind back, its stimulus program. The prevailing theme still swings between risk-on/risk-off. When confidence in a sustained US recovery and further evidence of China having managed a slowdown, and beginning the transition to a domestic consumption-led economy flows back into the markets, a more long-lived ‘risk-on’ move will definitely favour the small-caps.

So how best to play this sector?

You could research small-cap stocks yourself; which is a potentially rewarding (and very interesting) process. Or you could outsource the effort to a specialist manager, which will be better-placed to pick up the benefit of information arbitrage.

Some of these funds have been very good performers, beating the market handsomely. While past performance cannot be used to predict future performance, clearly it is a relevant statistic.

On Morningstar data, here are the stand-out performers among Australian small-cap funds over the past 10 years.

Looking forward, research house Zenith Investment Partners rates its top three Australian small-cap funds as Celeste Australian Small Companies Fund, Fairview Emerging Companies Fund, and Ironbark Karara Small Companies Fund.

The listed investment company option

Then there are the listed investment companies (LICs), which do a very good job of their stated mission, which is compounding share price rises and dividend income to generate long-term capital growth. For self-managed super fund (SMSF) investors, LICs are an excellent way of holding a stock that delivers instant diversification and a decent shot at outperforming the market return.

While the big LICs focus on the large-cap end of the stock market, there is a sub-sector of the LICs that invest in the small-cap space.

Leading LIC analyst, William Spraggett of Bell Potter, says the two best-performers of this group, WAM Capital (WAM) and Mirrabooka (MIR) Investments, have been “unparalleled performers,” generating pre-tax NTA growth of 12.9% a year and 12.3% a year for the decade to 30 June 2013.

Compounding that attraction, he says, Mirrabooka this week announced a 6.5 cent dividend and a 5-cent-a-share special dividend.

Spraggett says neither WAM nor MIR have large material stock positions that can heavily influence performance: WAM’s largest holding is GrainCorp, which is 6.1% of the fund, while waste management and industrial service provider Toxfree Solutions is MIR’s biggest position, at about 6.5% of the fund. He says WAM is a more aggressive trader than Mirrabooka.

One of the features of LICs is that the share price of an LIC can, and will, fluctuate around its net tangible assets (NTA) figure, which is the market value of the fund’s share portfolio divided by the number of units on issue. The NTA tells you the dollar amount of the portfolio’s value that ‘stands behind’ each unit.

What this means is that when the price is less than NTA, investors can buy an interest in a high-quality, well-diversified share portfolio for less than the cost of establishing that portfolio themselves. The reverse also applies, and an LIC’s share price can exceed the prevailing NTA.

At present, says Spraggett, WAM looks better than Mirrabooka on this score: the LICs’ NTA figures come out each month, but Spraggett models the figures on an intra-day basis. He reckons WAM is trading at a 2.8% discount to NTA, while MIR has moved to an 8% premium over NTA. While that appears “fairly fully valued,” he says the excellent long-term investment track record is an attraction to investors who believe that the small-caps sector “could run pretty hard” from here.

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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