Markets: Hitting the small time

Small caps are getting ready for their time in the spotlight.

A weaker currency would once have been seen as correlated with poor small cap performance, with both reflecting risk-off attitudes. In the current economic climate, the falling dollar is actually promoting an earnings tailwind.

The ASX 200 has steamed along over the past 12 months, generating a total return of 27 per cent, leaving the small cap index in its wake. The smaller end of town, which includes stocks between the ASX 100 and ASX 300, has only provided a total return of six per cent.

Looking at the last five years we can see the pronounced difference emerging between the two. The yellow line is percentage change of the ASX 200 against the ASX Small Cap Ordinaries in the white.

Source: Bloomberg

By companies hedging their currency exposure anywhere between three to 12 months out, it will take some time for the lower currency to have a meaningful impact on company balance sheets. Once this has filtered through, companies with currency exposures will be in a better position.

Adding to this, small caps are supported in the immediate term by lower interest rates from monetary stimulus.

A hot pursuit of yield, encouraged by hefty dividends offered on the Big Four banks and Telstra, has these companies fairly valued and trading around their intrinsic value. Less interest at the smaller end of town allows opportunity to exploit mispricing, and cash in on some value.

The falloff in commodity prices has seen smaller companies that focus on resources and industrials crushed, leading the index down. But with a bounce in commodity prices, a weaker Aussie dollar and improved global growth expectations, some value can be found across this sector.

Frank Villante, Chief Investment Officer at Celeste Funds Management, says investors should look for companies that actually produce and generate cash flows. Options across this space include AWE Ltd, covering oil and gas and Mount Gibson Iron Ltd.

Some of the retailers have had a spectacular run over the past 12 months, but it doesn’t mean their end is near. The key is to look for companies with dominant market shares in a specific geographical locations, according to Villante.

Breville Group is an interesting one in this space. Breville generates less than half of its revenue domestically, with North America providing around 40 per cent and New Zealand six per cent, ultimately insulating the company from the performance of any one economy.

Reporting season saw the likes of Fantastic Holdings temper earnings outlook for the year ahead based on the Australian economic climate. Without a dominant market position and another revenue stream they are heavily leveraged to the Australian economy. Not ideal in a time when domestic economic fundamentals are weak.

The risk-off attitude is dominating equities and the perception of investors is that there is greater comfort in the safety in numbers by chasing large caps. When domestic conditions begin to improve, which may not be too far away considering the aggressive monetary policy pursued this year, small caps will have more to gain than their larger friends. It is expected smaller companies will lead the way when investor sentiment turns around.