Small companies set to do better

Investing in smaller companies over the last couple of years has been a dud.

This huge generalisation is demonstrated by the following graph, that compares the total return of the market as measured by the S&P ASX 200 (red line) and S&P ASX 300 (light blue line), to the S&P/ASX Small Ordinaries (dark blue line).

If you are not familiar with the Small Ordinaries Index, this measures the performance of stocks ranked 101st to 300th by market capitalisation.

^[1]Over the last 10 years, the S&P/ASX 300 has returned 8.06% per annum, compared to a miserable 2.84% per annum for the Small Ordinaries Index.

Small companies

Small listed companies aren’t microcaps (there are more than 1,100 of the latter) – but they are still relatively tiny compared to the giants. In aggregate, they represent less than 7% of the total share market capitalization. At the bottom end, company number 300 has a market capitalization of around $200 million (Commonwealth Bank’s market cap is $152 billion). The median small company is around $530 million.

The top 10 small companies (stocks 101 to 110) are quite well known names:

Domino’s Pizza DMP
Qube Holdings QUB
Veda Group VED
M2 MTU
Platinum Asset Management PTM
Spotless Group SPO
NIB Holdings NHF
Fletcher Building FBU
Cromwell Property CMW
Slater & Gordon SGH

From an industry perspective, small companies are quite different to the top 20 companies. Consumer discretionary is the main industry sector at 24.5% of the index (by comparison, zero weighting in the S&P/ASX 20), with the financials sector down to just 19.5%.

^[2]

^[3]Why small companies might do better

With a heavy weighting of companies from the consumer discretionary, industrial and healthcare sectors, small companies might start to do better than their big cap peers. The big change is the weaker Aussie dollar, which has fallen from US$1.10 to US$0.77, and should make trade exposed and import competing companies more competitive.

Between 2011 and mid 2014, the high Australian dollar made life really hard for these companies. It also helped dampen consumer confidence (which impacted the discretionary retailers), as consumers became concerned about job security and saved rather than spent.

Interestingly, this high Aussie dollar period correlates reasonably closely to the period that the Small Ordinaries index lagged the main market.

Now that the dollar is lower, interest rates are down and there are signs that both consumer and business confidence is improving, smaller companies are set to do better. It is unlikely to be an even performance, however, as resource companies (miners and mining service companies) will still find the going tough.

How to invest in small caps

While you can, of course, buy some of the individual small companies, given the high degree of specific risk in undertaking this strategy, we will consider the managed options.

Firstly, using an Exchange Traded Fund (ETF). The iShares S&P/ASX Small Ordinaries ETF tracks the Small Ordinaries index. Trading on the ASX under stock code ISO, a management fee of 0.55% pa is charged. This means that over the long term, you should expect a total return of the Small Ordinaries Index less 0.55% – nothing much more, nothing much less.

Vanguard has the Australian Small Companies Index ETF (ASX Code VSO), which tracks the MSCI Small Companies Index. Management fees are lower at 0.30% pa. As the composition of the MSCI basket of small companies is different to the Small Ordinaries index (the MSCI has some larger companies such as Challenger and Orora), the returns are quite different. VSO has returned 5.22% and 2.78% pa for the 1 and 3 year periods to end February, while ISO has only returned 2.74% and a very disappointing -1.41% pa over these periods.

There are several LICs (listed investment companies) that specialize in smaller companies. They have very different mandates, are actively managed, charge much higher fees than ETFs and are not always true to label – so it is hard to make an “apples and apples” comparison.

The following table shows four LICs, the area of investment focus, 1 and 3 year performance returns, and a comparison of its Net Tangible Asset Value (NTA) and closing ASX market price on 27 February.

^[4]With a LIC, an important consideration is the discount or premium to NTA. The NTA of course represents what the company is really worth on a per share basis – the market price on the ASX is what the shares are changing hands for. In a bull market, LICs tend to trade at a premium, and in a bear market, they tend to trade at a discount. LICs with a stronger and more consistent performance record, or higher profile manager, tend to trade at a premium – while newer LICs, or those from less well known managers, tend to trade at a discount.

At the end of February, Mirrabooka and WAM Capital were trading at premiums – while both Contango and NAOS were trading at discounts. Interestingly, the former LICs include some mid-caps in their investment universe (and have performed quite strongly over the last few years), while Contango and NAOS only invest in smaller caps.

Bottom line

I am not convinced that an ETF is the right vehicle to invest in smaller caps. Firstly, because the exposure to second and third tier resources companies cannot be eliminated, and secondly, the ex-100 part of the market is poorly researched and some active managers are able to demonstrate year in, year out performance in this sector of the market.

Although WAM Research invests in some mid tiers, if it can be purchased at close to its NTA, then it looks the pick. As you may also want to diversify your manager risk, both NAOS Emerging Opportunities and Contango Microcap are trading at discounts to their NTA and offer value.

How much? Well, this part of the market is around 7 to 10% of the total market. So, if 0% of your equities portfolio is in smaller caps, you are underweight – if you have 20%, then you are overweight.

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.