A small-cap strategy that works

PORTFOLIO POINT: Small caps aren’t always winners, but there are specialist investors able to constantly beat the market. Here’s how.

It is widely held that investments in small companies should outperform large companies over the long term, and Michael Feller’s analysis of his 2010 Under the Radar small-cap stock picks nicely supports this theory (click here).

This premium is your reward for investing in inherently riskier companies. Given the high concentration of big-company banks and resource companies in the Australian All Ordinaries index, and consequently in most investor portfolios, perhaps investing in small companies could be a sensible way to more safely diversify your portfolio.

In this article we’ll look at whether there is a “small-company effect” locally and, if so, how can you go about getting it into your portfolio.

US investor experience

Academics Rolf Banz in 1981 and then in 1992 Eugene Fama and Kenneth French as part of their “three factor model” divined from studying long-term US stock returns that a premium exists for investing in small companies.

For the 83 years from 1927 to 2010, the annual returns from investing in the smallest 50% of US listed companies returned 11.7% versus 9.9% for investing in the mainly large company S&P 500 index. This premium isn’t always present, however, as sometimes small companies underperform large companies – as they did in the early 1970s and mid-1980s. One of the earliest international small-company fund managers, Dimensional Fund Advisors, points out that since 1927 investors in US small companies would have been rewarded with an extra return only 59% of the time if they invested for just five years and 75% of the time if they invested for 10 years. In other words, to be rewarded you need to be patient.

Australian inexperience?

Anecdotally it is expected that there is a reward for investing in small Australian companies, but there are few if any conclusive studies that prove this.

The most recent financial year certainly supports the premise that a diversified portfolio of small companies can be a rewarding investment. For the year to June 30, 2011, companies in the S&P/ASX Small Ordinaries index delivered a 16.4% total return compared to 11.3% for the ASX’s 20 largest companies. In the decade to June 30, 2010, the Small Ordinaries index returned 8.2% annually versus 7.2% for the ASX 300. The ASX 300 is about 85% by weight the largest 100 companies and 15% the Small Ordinaries – the next 200 sized companies.

Surprisingly, if you go back further, over 22 years to 1989, you find the opposite. The large-company All Ordinaries index beat the Small Ordinaries index by 2.4% – the former delivering a 9.4% versus 7.0% annual return. Confused? Perhaps so are researchers and this is why I don’t see local studies concluding the existence of a small company premium for you to chase.

As a general rule, small companies have a tendency to be shunned in falling markets (for instance after the 2007 GFC, 1998 Asia crisis and 2000 dotcom crisis) and rise faster in rising markets (2010-11). This means the higher returns come with higher volatility or standard deviation – also highlighted in an earlier article (see The silent killer of retirement savings). Because of this, most professional investors limit the percentage of investments in small companies to about 20% of equities.

Rethinking the benchmark

In my opinion, the problem is actually the small-company benchmark index. This index is made up of companies ranked between the top 100 and top 300 stocks. A company market capitalisation needs only to be $57 million to be included in this index. Not surprisingly then the index includes highly speculative companies, such as one-mineral, one-mine companies that are not generating any profits – or perhaps even cash.

Similarly, during the dotcom era of the late 1990s and early 2000s, many “vapourware” internet startups would have occupied the index. It is quite likely the presence of these unsustainable businesses doesn’t make for sound long-term investing and that drags down returns over the long term.

This isn’t an issue in the large-company index because it is harder for “hot one day, bankrupt the next” companies to squeeze into the queue between BHP and Newcrest, which make up the top 10 largest companies (and which account for about two-thirds of the MSCI 200, All Ordinaries, ASX 300 or similar major market index returns).

I’ve noticed Dimensional Fund Advisors screens out 30%, or 150 of the 480 companies, in its Australian small company fund’s size universe for reasons such as illiquidity, limited trading history, financial distress or for being an investment, holding or foreign company.

This makes it a better proxy for looking at the rewards possible from investing in small companies, as it best reflects the returns from managed funds specialising in small companies.

Case study and alternate benchmark?

Let’s have a look at the small companies fund management sector: the longest-running small company fund in Australia is Invesco’s Australian Smaller Companies fund, which started in 1988 – 23 years ago. This fund has been uniquely managed for the past 10 years by Cynthia Jenkins, who has been part of the fund since 1994. She is one of Australia’s few and perhaps only female money managers.

Jenkins (left), who recently was kind enough to take me through the history of the fund and the evolving Australian small-company investment universe, says being also a mum and the daily sandwich maker helps to keep her grounded. The returns from this fund are probably also a good proxy as it has now become one of the largest, with close to $1 billion under management, and it invests in a broad range of 50–80 companies, turning over about 20% of the portfolio each year.

Since inception this fund has had an impressive 12.6% annual return, net of fund fees compared to 5.8% for its Small Ordinaries benchmark and an estimated 9% for the larger-company All Ordinaries. The fund pursues a “value plus catalyst” style, meaning it shuns high-octane, high-risk speculative companies and avoids tracking an “index contaminated with unsustainable businesses”.

In its time the fund enjoyed returns from many independent companies that have since departed the ASX. It was invested in small, gobbled-up independent banks such as Challenge and Bank of Melbourne; casinos such as Burswood, Crown, Jupiters and Townsville; and transport companies like Patrick, Lang Corp and Finemores. In the early 2000s it avoided dotcoms, instead having a 12% holding in various small wine companies later absorbed by Southcorp and Foster’s.

In the past 18 months an unusually high 25% of companies held in the Invesco fund were acquired including Wattyl, Healthscope, Macarthur Coal, Austereo, Equinox, Citadel, and Coal & Allied – this feeding frenzy indicating companies are finding organic growth difficult and instead are using mergers and acquisitions to enhance profits.

Jenkins believes the index has a tendency to be “pregnant with what is most fashionable”. For instance, small miners and energy companies were 24% of the index in 1995, shrunk to 15% in 2000 then grew to 40% in 2010 – even peaking at 46%.

Your options for harnessing a small-company premium

You currently have three options for adding small companies into your portfolio, including buying stocks yourself, investing in a number of small-company managed funds and investing in two new index ETFs.

Buying stocks yourself is a fun way to add some speculative sizzle to your portfolio and perhaps back some of your own positive experiences interacting with these companies; for instance, ARB Corporation Ltd if you are a four-wheel driving enthusiast.

However, you should consider these as satellite investments to your core blue-chip company exposure. As shown in a previous column (see Put your portfolio into orbit) investing in 10 or so companies makes it quite possible to underperform the benchmark if just one of your companies implodes – something that can happen easily with small companies. To more reliably introduce any small company premium, it is better to invest with others in a pooled fund holding at least 30–50 stocks.

Morningstar’s recent fund roundup, to June 30, 2011, provided returns for 41 Australian small company funds operating last year and 24 funds that have been around for the decade. In the latter case, 83% of small-company funds bettered the index after fees. This compares to only 47% of actively managed large company funds doing so. This supports the thesis that an active management or filtering style can add value in small-company investing and not necessarily in large-company investing. The figure below shows the range in returns observed for small and large company active funds.

The best performing fund was the NovaPort Premier Smaller Companies fund; the worst was the Goldman Sachs Emerging Leaders fund. The spread of fund manager returns is much larger among small-company funds than large-company funds; this is because small-company managers can and are much more free-ranging in their stock selection and sector weighting. Our benchmark Invesco fund, for instance, is currently overweight 31% in industrials versus 18% in the small companies index and has only 20% invested in energy and mining, compared to a combined 40% in the index.

Vanguard and Black Rock have recently released exchange traded index funds (ETFs) specialising in Australian small companies. Vanguard’s fund tracks the MSCI Australian Shares Small Cap index, which “provides coverage of the small segment of the market which is easy to implement and requires less turnover”, while Black Rock’s iShares fund tries to track more diligently the S&P/ASX Small Ordinaries.

These funds are your cheapest way to access the returns from a diversified portfolio of small companies given their fee expense ratio of 0.3% and 0.55%, respectively. However, time will tell whether it is smarter to add small companies into your portfolio using these passive funds rather than more active or selective managed funds.

Some of the time, small is indeed beautiful when it comes to investment returns, I suspect even in Australia. Given the highly concentrated, big banks and resource companies nature of our sharemarket, there is an imperative to diversify further. Doing so through small companies in a small proportion makes sense to me.

Doug Turek is managing director of family wealth advisory and money management firm Professional Wealth.