Small, but don't throw them back
Market minnows can move fast, but they also get eaten, John Collett says.
Smaller listed companies can add zing to anyone's share portfolio. The market's minnows are often overlooked by analysts who are all over the market's giants. And for those who know what to look for, such as the fund managers who specialise in smaller companies, there are big rewards on offer.
It has been a bumper 12 months for high-quality smaller companies and the managed funds that invest in them. The Smallco Investment Fund returned 54 per cent for the year to September 30, making it the best-performing smaller companies fund for the 12 months. Other smaller company funds had a stellar year as well. While the rewards are there, so are the risks. The market's minnows can shine brightly only to crash and burn spectacularly.
Tom Whitelaw, head of research at Morningstar, says smaller listed companies can add spice to a share portfolio but they should not replace the mainstays of a portfolio; the household names that spit out reliable, fully franked dividends with consistently-growing earnings. Whitelaw says when investors turn fearful the smaller stocks tend to be sold off more heavily than large companies. Small companies usually pay out less of their profits as dividends to shareholders than do large companies.
Dividends provide a ballast to returns when the share prices are heading south. And those in retirement are likely to favour steady dividends. But many of the favoured companies are trading at, or near, record highs because investors are chasing yield and the certainty of their dividends.
Richard Hemming, analyst and editor of Under the Radar, a newsletter covering small companies, (and a regular Money contributor) says it's the big-dividend payers who are carrying more risk at the moment. He says their share prices are vulnerable if there should be a softening of their earnings growth. But he says there are just many more opportunities to discover hidden value among the smaller companies.
Of the 2200 companies listed on the Australian sharemarket, almost 2000 have market capitalisations less than $300 million and most are not followed by analysts. Nor are they worthwhile for most fund managers to hold because fund managers cannot get meaningful stakes in the companies, Hemming says. But when they grow, they come on to the radar of the fund managers and big returns can ensue, he says.
For this reason, Hemming advocates investors have some exposure to investing directly in the shares of smaller companies.
Two of his best calls include Silver Chef, a hospitality equipment funding business, and Freedom Foods, which makes allergen-free food. He bought the stocks early, but when they started to be bought by fund managers their share prices soared. A small company can also be a takeover target, the shareholders in the smaller company being offered a premium for their shares.
Small fry fly
The smaller company fund managers that have done best over the past year have not held smaller mining stocks which, along with their big resources counterparts, have had a tough 12 months. The Smallco Investment Fund holds 19 stocks and has done particularly well from its shares in Altium, which develops software for the electronics industry. Another good long-term performer for the fund is IRESS Limited, which is the dominant supplier of market data to investment professionals in Australia.
Rob Hopkins, co-founder of Smallco Investment Management, says many smaller industrial companies have had a good run and the shares of many are now over-valued. He is not expecting the Smallco Investment Fund's 54 per cent return to be repeated over the next 12 months. But while he thinks companies such as IRESS and ResMed, sleep disorders equipment maker, are over-valued he takes a long-term view. He expects the share prices of both companies to be significantly higher in three years' time. And anyone investing in shares has to take the long-term view.
The Hyperion Small Growth Companies Fund has one of the best track records of any smaller companies fund. For the year to September 30, the fund returned almost 43 per cent. That performance is no flash in the pan. Over the 10 years to September 30, the fund has an average annual return of almost 18 per cent; almost 20 per cent over five years and 19 per cent over three years.
Mark Arnold, the chief investment officer at Hyperion Asset Management, says the good returns have been "pretty broad based", though it has done well from online plays - real estate site REA Group and jobs website SEEK, which the fund sold when it entered the top-100 index. He says the fund has done well from its holdings in REA Group, Caresales.com and Sky Network Television, among others, during the past 12 months.
The Hyperion Small Growth Companies Fund is not invested in the resources sector. "Our bias is towards quality businesses," Arnold says. The fund does not hold resources stocks because most of those outside of the 100-largest are poor quality, he says. Arnold is forecasting the fund should be able to produce an average annual return of 18 per cent for the next five years. That is in line with its long-term returns; though the fund is unlikely to reproduce the one-year return of 43 per cent again over the next 12 months, Arnold says.
OC Dynamic Equity Fund has produced a return for the year to September 30 of 42 per cent and an average annualised return to the same date of 9 per cent over 10 years. The fund can have up to 20 per cent of its holdings in top-100 stocks and typically does not invest in resources stocks. "We will only invest in stocks that we can forecast the key drivers of the business," says Robert Frost, the head of investments at OC Funds Management. The fund typically holds about 35 stocks. "Some of the quality names are becoming expensive and we have sold some of those on valuation grounds; though they remain great businesses," Frost says. One of those is REA Group. It is still a quality business, but Frost says its shares are "priced for perfection".
Shares researcher and publisher Intelligent Investor launched a funds management business three years ago. Its Intelligent Investor Value Fund has returned almost 43 per cent over the year to September 30 and has a three-year average annualised return of 22 per cent.
Matt Ryan, investment analyst at Intelligent Investor Funds Management, says the fund typically owns a relatively small number of stocks, usually fewer than 20, and these stocks can be small and illiquid. The fund can hold the occasional large stock. It is managed with a "value" investment style.
While some funds are focused on finding small companies that are going to become large companies "we have done a bit of that and have had some success", Ryan says. But the investment management team also looks at those companies that are doing it tough and the fund has made good money from "turnaround" stories.
"We pick through some of the uglier ducklings," he says. The fund has done well from some property trusts such as Ingenia Communities Group, the old ING Real Estate Community Living Group. The retirement village group, like many other property trusts, was caught with too much debt during the global financial crisis.
The fund has also done well from RNY Property Trust which, although listed in Australia, owns suburban office assets in the US. Ryan cautions that investors should not expect the same bumper returns over the next 12 months. With the smaller companies market having done so well, it is harder to find good value smaller stocks than it was a year ago.
"Most of the fund managers, if they are being honest, would say they are having a tougher job finding good ideas than they were 12 months ago," he says.
Watch John Collett and Morningstar's Tom Whitelaw discuss the opportunities in the small caps field at theage.com.au/money
Best performers in the small caps field
Experts' top tiddlers
ResMed Ltd (RMD); leading maker of medical equipment for breathing difficulties when sleeping and other respiratory disorders.
IRESS Ltd (IRE); dominant supplier of market data to investment professionals in Australia with increasing presence overseas.
SEEK; jobs website that is expanding around the world.
RNY Property Trust (RNY); owns office property in the New York region.
Antares Energy Ltd (AZZ); international hydrocarbon exploration and production company.
Jumbo Interactive (JIN); online lottery sales company that is expanding around the world.
REA Group (REA); operator of Australia's most popular residential and commercial real estate websites.
IRESS Ltd (IRE); dominant supplier of market data to investment professionals in Australia.
Henderson Group (HGG); fund manager with operations in Europe, Asia and the US. Dual listed in Australia and UK.
OC FUNDS MANAGEMENT
Sky Network Television (SKT); New Zealand pay-TV operato.
SFG Australia (SFW); independently owned financial services company.
Virtus Health (VRT); provider of fertility services in Australia, operating on the eastern seaboard.
UNDER THE RADAR
Servcorp (SRV); provides contracted serviced offices in Australasia, Asia and Europe.
Clover Corp (CLV); produces natural oils as well as producing chemicals for the pharmaceutical industry.
Infomedia (IFM); develops and supplies electronic parts catalogues for the automotive industry.