Funds face shrinking universe due to takeovers

Adding to the thinning out of the Australian equities market, fund managers told BusinessDay, was the static initial public offer (IPO) market, which has cut off supply of new industrial stocks.

"One of the things that refreshes the pipeline for fund managers and investors generally is a good IPO market and that has been stuffed for five years," Donald Williams, of Platypus Asset Management, said.

"The market is becoming more narrow because you have these six mega-caps - the big four banks, BHP Billiton and Rio Tinto - that account for a massive part of the index and it's sort of hard to add value."

For many of the nation's largest fund managers, this has forced them to investigate middle-size companies and small-caps, in an attempt to unearth tomorrow's top 20 leaders and eke out premium returns. Some institutional investors are the most heavily weighted in mid to small-caps since before the global financial crisis.

Australian Unity Investments chief executive David Bryant said the increasing concentration among the largest companies and their weight compared with the rest of the index has been a problem for fund managers for some time.

"The top 20 stocks are more than half the market capitalisation in Australia and are very heavily weighted to resources, financials and the big insurers - and when you talk about liquidity and size it does fall away quickly from there," Mr Bryant said.

A quick scan of the ASX's biggest stocks highlights the current dilemma. The "gang of six" - BHP Billiton, Rio Tinto, Commonwealth Bank, Westpac, ANZ and National Australia Bank - account for just under 40 per cent of the S&P/ASX 200 in terms of index weighting.

The takeover of Foster's will remove the only large listed beer business on the public market and its 18th biggest stock. Its departure will also leave only five companies in the top 20 that aren't financials, resources or energy plays - that is, old-fashioned industrials.

It gets worse the higher up the index investors go. Only two stocks in the top 10 (Telstra and Woolworths) are not banks or resources companies.

"I don't think its a problem with takeovers, more a problem with the commodity prices," the managing director of Orbis Investment Management, Simon Marais, said. "It has skewed our whole capital allocation to such an extent that all the money flows into resources and that's why it becomes the whole index."

The chief executive of Argo Investments, Jason Beddow, said the Australian market was lacking a vibrant technology and healthcare sector, for example, with these sectors typically providing diversification.

"Australia is a very concentrated market. You have got a couple [of] big resource stocks, four big banks and one or two retailers that dominate and that's about it."

Mr Beddow, whose company looks after an equities portfolio valued at more than $3 billion, said the poor IPO market has made the concentration problem worse.

"It's a fairly skewed market already. The industrial side ... has been probably shrinking for the last decade as banks and the resources have grown. So to be able to invest across the broader spectrum of the economy, from that perspective, it is becoming more limited.

"Since the GFC, so nearly five years, we haven't had a strong IPO market. Plenty of small resources floats ... but not really investable for the big guys and we are not getting those new industrials."

Mr Marais agrees, saying the IPO assembly line had almost ground to a halt. "It's not that the takeover cycle is too high, I think the replacement cycle is too low," he said.

Mr Williams - whose Platypus Asset Management is part of the Australian Unity group, which has more than $1 billion in funds under management - said the growing dominance of a few stocks also created earnings problems for managers.

"All six of those mega-stocks are relatively lacklustre when it comes to growth. BHP and Rio have only got 2-4 per cent volume growth and it's basically just a call on commodity prices, while the banks have got very slow earnings growth over the next few years."

Mr Williams said his search for better value and returns had seen his funds dive more into mid-caps and small-cap stocks.

"We are doing more in mid-cap and small-caps than we have since 2004-05. We are doing less in top 20 than we have done for a long time trying to find growth."

The head of equities at Ausbil Dexia, Paul Xiradis, said it wasn't an impossible task for fund managers to find diversification outside the top 20 and with share prices generally so low it provided a great opportunity for investors.

"The Australian market has become more narrow but you just have to be more selective. You need to take a wider look at the market," he said.