Small caps on a winter run

The stars are aligning for small caps to outshine large stocks in the winter run.

Summary: The month of May, heading into winter, is usually a gloomy time for the stockmarket. But the small caps sector, having underperformed the bigger end of town, is tipped to surge ahead in the medium term.
Key take-out: The S&P/ASX Small Ordinaries Index is lagging the top 100 stocks by the widest margin on record.
Key beneficiaries: General investors. Category: Growth.

It takes a brave investor to move against the market, but this could be the time to be thinking about rotating out of large caps and into small stocks.

Such a contrarian move would send shudders down the spines of most, especially given the woeful performance at the small end of the market.

If that wasn’t enough to make you feel nervous, try using the old market adage “sell in May and go away” to justify the rotation. May tends to be a terrible time for stocks. In fact, that month is the weakest period for large caps.

Over the past decade, the S&P/ASX 100 Index has recorded an average loss of 1.4% in May, and robust gains in the March quarter typically increases the probability and magnitude of the sell-off.

It is easy to understand why there is growing apprehension that this adage could come charging through with a vengeance this year given that the top 100 stocks have made a spectacular 11% gain in the last three months, thanks to yield-starved investors snapping up defensive-income generating stocks, such as the banks and Telstra.

While small caps are not immune from the seasonal weakness, the period has historically heralded the start of the “small cap winter run” – a time when small caps outperform their bigger rivals.

In the past 10 years, small caps have on average generated returns of 2.7% from May to August – or close to four times that of the top 100 stocks.

But the May correction could come early this year. RBS Morgans’ technical analyst, Violeta Todorova, believes the charts are looking very toppish for the S&P/ASX 100 index.

“The top 100 is looking extremely over-bought,” said Todorova. “The resistance is around 4400 and I can’t see it going much higher in the shorter term.”

Resistance refers to a psychological level that caps the market as it normally draws in sellers. The ASX 100 index is around 4% below this level.

While experts will tell you that history doesn’t repeat, they say it rhymes; and there are a number of reasons to believe that small caps will be humming along nicely as winter approaches.

The first is the “revision to the mean” principle, which is almost always respected by the market.

The S&P/ASX Small Ordinaries Index is lagging the top 100 stocks by the widest margin on record, with the small cap benchmark dipping around 3% into the red over the past year while the S&P/ASX 100 Index surged by 25%.

Even if you were to ignore embattled small resources stocks, which accounts for a large part of the underperformance of the small ordinaries, the difference in performance between small and large is still very hard to ignore.

If history is any guide, junior stocks could outrun the big end of town by a whopping 11 percentage points in the coming months if they were to revert to the mean.

Besides the “revision to the mean” argument, the technical indicators (i.e. share price movements) are supportive of this year’s small cap winter run. But unlike the past years, the outperformance of junior stocks could continue right through to the end of the year.

“The small caps don’t have the same over-bought [signals] as the large caps, so they don’t necessarily have to correct. They can keep going and they have the momentum to keep going,” said Todorova.

“Also, the big banks go ex-dividend in May and they have a large weighting in the ASX 100 index.”

The lack of dividend support and the uncertainty ahead of the federal election in September are likely to keep large caps on the back foot. Small caps, which are generally more event driven (i.e. share price gains depend more on hitting milestones), are arguably a little more removed from the political cycle.

While Todorova believes the bull market is intact and any sell-off would be relatively shallow at between 3% and 5%, she sees more upside for the small caps.

The S&P/ASX Small Ordinaries Index has a 25% upside to her year-end target versus 17% for the top 100 benchmark.

Valuations are also generally supportive for smalls. While critics will point out that the price-earnings (P/E) ratios of smalls compared with large paints a downbeat picture for the small end of the market, the price to book value (P/B) ratio is saying quite the opposite.

Earnings are a challenge to forecast in the best of times, let alone in these volatile times we find ourselves in.

For this reason, I would put a little more faith in the P/B measure at this juncture as it compares the share price with the asset value of the company as a measure of “cheapness”; and this measure for small caps has plunged 50% relative to large caps over the past 12-months.

This doesn’t necessarily put small caps deep into bargain territory, but it does imply that small caps have a fair bit of room to play catch up.

Another encouraging factor is the ability for companies to tap shareholders for extra funds. Securing fresh capital in this market is still tough, but a number of small caps have successfully raised a significant amount of capital this year.

This includes stem cell technology biotech Mesoblast with a $170 million raising, homeware products supplier McPherson’s with a $24 million raising, and Dart Mining with a $10 million capital injection (which is half the market cap of Dart).

Australian companies have managed to get about $1.8 billion in equity capital since the start of the year, according to data from Dealogic, which is 5% more than for the same time last year.

The availability of capital has a bigger impact on smaller company performance than large.

The stars are finally aligning for juniors, barring another crisis rocking global markets. Investors thinking big, should be going small.

Brendon Lau is the editor of uncapped and may have interests in some of the stocks mentioned in the article.

Graph for Small caps on a winter run

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