Small resources, big returns

It’s been a year since we last covered Australian small-cap managed funds and what a year it’s been for the sector, with a benchmark return of 44.4% – the highest return of all the major asset classes for 2006-07. Within the sector, the best place to be was in smaller resource stocks with the small-cap resources sector up 64% for the year. The majority of our preferred small-cap funds produced outstanding results for the year, with Pengana Emerging Companies Fund returning 70% and Challenger Microcap fund up 68%.

The strength of both the global and domestic economy helped power small companies as they benefited from strong commodity prices and the growth in demand within the economy.

With this sector it’s all about stock picking, a highly specialised skill that reinforces our preference in using a managed approach in obtaining this exposure. Meeting management face to face along with company visits are the single best screens you can use in gaining a feel for a smaller company because broker research on this sector is rarely available.

It’s here that a specialist manager (instead of going directly) has the ability to add real value as most small-cap managers regularly visit and speak to management regarding the companies they invest in, and it’s this “ear to the door” ability that allows them to judge buying or selling opportunities much better than you can as a distant shareholder.

Outlined in last year’s article was our approach to building an exposure to this sector by splitting it up into three areas:

• Mid-caps (ASX 50 – ASX 150)
• Small caps (ASX150 – ASX300)
• Micro caps (ASX300 – ASX1800)

By allocating a portion of your portfolio to each area you’ll ensure that you are not overweight to any particular one. We recommend selecting a fund for each of the three sectors and proportion an appropriate amount of capital to each, such as Ausbil for mid-cap exposure; Pengana for small-cap; and Challenger for your micro-cap exposure. In most portfolios a weighting of about 5% of the combined portfolio balance is recommended as an appropriate allocation.

The Mid Cap Funds

Ausbil Dexia Australian Emerging Leaders Share Fund

Ausbil is a joint venture with senior staff and Dexia Asset Management. Ausbil combines both top-down and fundamental research to target companies in the S&P/ASX Mid Cap 50 Index. The manager believes that value can be added by concentrating on this market segment versus investing in stocks in the S&P/ASX Small Ordinaries Index on the premise that it is not over-researched by the market. Their benchmark reflects this being 70% S&P/ASX Mid Cap 50 Accumulation Index and 30% S&P/ASX Small Ordinaries Accumulation Index.

Ausbil is one of the few Australian shares managers that actively conducts top-down analysis to concentrate on companies most likely to outperform in the coming year. They are also style neutral; not value or growth oriented.

Paul Xiradis and his investment team have had another good year with this fund, although they underperformed their benchmark over the year to June 30, 2007, returning 28.44%. Major contributors to the return were holdings in Transfield Services (services contracting and project management), Smorgon Steel (steel manufacture) and Singapore Telecommunications. The fund has outperformed over three and five years.

Opis Capital Dynamic Equity Fund

Opis Capital is a Melbourne based boutique Australian equities manager that runs two Australian equity funds (Premium Equity Fund and Dynamic Equity Fund), both with an absolute return objective. Their Dynamic Equity Fund (opened in December 2000) has an investment strategy to invest in a broad range of ASX-listed companies, with a focus on smaller to mid-cap companies with further value being added by allocating a small proportion of the fund to short-term trading opportunities in ASX listed securities.

Opis does not manage the fund against any index but instead sets a high absolute return objective of 10–15% over the long term. The fund will typically hold 25–65 listed securities, will not invest more than 11% of the portfolio in any one position and does not short sell securities or use derivatives.

The investment team consists of Dean Fergie (head portfolio manager), Sam Baillieu and Robert Frost. All three have been with the manager since inception. The fund can invest in all companies listed or about to be listed on the ASX subject to a minimum market capitalisation of $20 million, with most investments being in companies that have a market capitalisation of $50 million or above.

In the year to June 2007, the fund underperformed the benchmark, returning 30.1% which reflects the fund having no exposure directly to the mining sector. Major contributors to the return were holdings in Clive Peeters, Hastie and Sunland, while Timbercorp was one of the major underperformers.

The Small Cap Funds

Eley Griffiths Group Small Companies Fund

Eley Griffiths Group is a boutique fund manager specialising in Australian small companies. It is jointly owned by Brian Eley and Ben Griffiths, former small companies’ portfolio managers at BT Funds Management and ING Investment Management.

Their Small Companies Fund investment process is based on the philosophy that markets do not always price small companies efficiently and that these inefficiencies can be exploited using market experience, research and stock selection process.

The manager is an active manager of small companies and describes their approach as “growth at a reasonable price” (GARP). The fund’s investment mandate covers small companies outside the top 100 listed companies which have a market capitalisation above $50 million. If a stock moves into the ASX 100 the fund has a requirement to sell within two years. The fund aims to outperform the S&P/ASX Small Ordinaries Accumulation Index by 6% per annum (pre fees) over three year rolling averages. The portfolio will normally hold 35–55 stocks with a portfolio turnover on average between 60–80% per annum.

Over the year to June 2007 the fund returned 40.02%. The fund does hold exposure to the mining sector and returns reflected this with holdings in Sally Malay Mining and Kagara Zinc adding to the return.

Pengana emerging companies fund

Pengana Capital is a boutique funds management business that provides seed funds for new managers. This fund is therefore jointly owned by Pengana and the two managers that started it; Steve Black and Ed Prendergast.

The fund utilises a robust investment process that combines in-depth fundamental research with disciplined portfolio construction and risk controls. An active company visitation program and the maintenance of strong relationships with company management are at the forefront of this process with Ed and Steve visiting the companies together before making their investment decisions.

Their investment decisions are also value-based; they believe superior returns are achieved by investing in undervalued companies. Although classified as a small cap fund, we note that the fund also invests across the mid-cap and micro-cap segments, which investors should be aware of. Interestingly, the fund does not invest in resources stocks, which we like as it allows an investor to control this exposure using the large companies such as BHP Billiton, Rio Tinto and Woodside Petroleum.

In the year to June 30, 2007, the fund outperformed the benchmark, returning 71.8%. Major contributors to the return were holdings in Bradken (services and heavy equipment contracting), Mineral Resources (mining services and processing contracting) and Incitec Pivot (fertiliser producer). The strong performance was driven by those companies exposed to the resources sector.

Aberdeen Australian Small Companies Fund

Deutsche Australia sold its funds management arm to Aberdeen International in March 2007, hence the change of name from the Deutsche Australian Small Companies Fund. There is a degree of risk surrounding the management of this fund after the takeover, noting that some staff have left the business. This is a key risk associated with managed funds that we believe investors should try and mitigate by using fund managers that have ownership of their business. In this case we have switched our preference of this fund across to the Pengana.

The micro cap funds

Challenger Microcap Fund

The methodology, style and management of this fund have not changed. It continues to invest in micro-cap companies with a market capitalisation of less than $150 million using a research-based approach to find companies that 1) have a strong or improving business franchise, 2) financial strength and 3) a share price trading at a significant discount to their assessment of the share’s fair value. The fund can hold between 25 to 65 stocks and the cash holding can be anywhere between 0 to 40% of the fund (16% as at 30/06/2007).

Over the year to June 2007, the fund outperformed the benchmark returning 68.32%, reflecting value found in the industrials and materials sectors of this market segment. Major contributors to the return were holdings in OM Holdings (manganese producer), BlueFreeway Ltd (interactive marketing and communications) and Blue Energy Ltd (coal seam methane gas producer). The strong performance was driven by earnings increases (fundamentals), which the manager does not expect to be replicated next year.

Australian Unity Acorn Capital Microcap Trust

Acorn Capital is an active manager of Australian micro-cap shares. They are owned 50% by Australian Unity Group, 47% by staff and directors. The fund invests in a diversified portfolio of listed Australian shares outside the top 250 by market capitalisation. Many of these companies are at a relatively early stage of development and rely on their innovative technologies, research, exploration or development to increase shareholder value.

Acorn divides its universe into two segments; developing companies and mature companies. Developing companies are companies that have virtually no revenue (little cash flow, earnings, etc). Acorn generally has an 80% weighting to mature companies and a 20% weighting to developing companies. They focus on stock selection, using quantitative and qualitative processes, with an emphasis on management and relative valuation.

The portfolio is constructed using 60–80 stocks and the manager is very mindful of the thin capitalisations in this end of the market, hence takes a disciplined approach to trading in and out of stocks. Over the year to June 2007 the fund returned an incredible 51.7%. Some of the largest holdings in the portfolio are Macmahon Holdings (6.15%), Aspen Group (4.10%) & Oakton (3.96%).

Conclusion

The strong performance of the sector overstates why it is important to have an appropriate allocation to this sub-asset class. The variability in returns among managers illustrates the risk associated with this end of the market and why it pays to outsource to a manager. And if the risk doesn’t scare you off doing it yourself, we are sure that paying a manager 2% for 20% outperformance is worth considering!

nHow they've performed
Mid-cap, small-cap and micro-cap funds	Start date	Fund size ($m)	Min invest ($)	Indirect cost ratio (%)	Performance (%)
					One year	3 years	5 years
Ausbil Australian Emerging Leaders Fund	1/05/02	802.4	50,000	0.85	28.44	32.99	27.87
Opis Capital Dynamic Equity Fund	20/12/00	173.6	25,000	1.72	30.10	27.30	24.90
Eley Griffiths Group Small Companies Fund	12/09/03	419.5	25,000	1.25	40.02	36.98	–
Aberdeen Australian Small Companies Fund	1/04/03	89.2	25,000	0.90	32.77	29.51	–
Pengana Emerging Companies Fund	1/11/04	399.3	25,000	1.33	71.80	–	––
Challenger Microcap Fund 21/03/05	21/03/05	80.5	20,000	2.00	68.32	–	–
Aust Unity Acorn Capital Microcap Trust	27/02/01	247.9	25,000	1.65	51.70	33.60	28.70
ASX Acc Small Cap Ords					44.43	32.17	24.88