Big possibilities in small caps

What do you do when yield becomes expensive? If you sit on the boards of Australia's largest companies, you succumb. Over the past five years investors have rushed into stocks paying fat, regular dividends with big companies like the banks, Telstra and Wesfarmers the primary beneficiaries. When boards have delivered on the expectation of higher dividends, higher share prices have typically been the result.

The numbers tell the story. According to the recent RBA March Quarter bulletin, in 2011 listed companies paid out less than 60% of profits as dividends. By 2015, that figure had increased to 80%. AMP has publicly committed to a dividend payout ratio of 70-90% of underlying profit. Commonwealth Bank is aiming for 70-80% and Woolworths is looking to pay out 70% of after-tax profit.

As we wrote in What to do when yield becomes expensive, ‘a company isn't worth more because it chooses to distribute profits rather than reinvest them'. That point has been emphasised over the past year by a raft of dividend cuts from large companies such as Woolworths, BHP and ANZ. In a low-growth world and with such high payout ratios, more will certainly follow.

The market seems to have finally cottoned on to this, with high yielding large cap stocks – including Telstra and Woolworths as well as the big banks and miners – suffering over the past year. The big banks are close to being upgraded while Woolworths and BHP already have been.

There is also an issue with expectations. In a deflationary world with interest rates at record lows, it's not realistic to expect the returns we've had in the past. Regarding the Woolworths turnaround, James Greenhalgh wrote in October last year that ‘we'd expect a long-term total return of mid-to-high single digits'. Back then the price was just under $25; it's now around $21. That makes it a more interesting opportunity but it hardly sets the pulse racing. Is this the best we can hope for?

Absolutely not. Cast your eyes down the list of stocks featured in our Okay yield and growth mini portfolio of 27 May 16. Alongside ASX, CBA and Westpac are a bunch of small and mid-cap stocks like Gentrack, PMP Ltd, Virtus Health and Trade Me. These are companies that have been prepared to invest and which are now reaping the benefits. For PMP that's resulted in a free cash flow yield in the high teens; for the others it means a reasonable yield combined with superior growth prospects.

For investors happy to get more of their total return from share price growth rather than yield, opportunities to earn outsize returns are still on the table. We intend to find more such opportunities, but to do so we need to move beyond the large and familiar.

Telstra has a market capitalisation of $65.8bn while current Buy List resident PMP has a total market cap of just $172m. The figures for Woolworths and Gentrack are $26.9bn and $200m respectively. With so many of the large cap stocks shooting themselves in the foot with a lack of investment, we've been spreading our net wider and we intend to spread it wider still.

Advantages of small caps

The reasons are obvious. First, because the top 20 stocks by market capitalisation account for about 60% of the ASX 300, they get plenty of attention. We're more likely to find mis-pricings among small caps because fewer analysts follow them. The fact that investors abhor risk right now increases our chances of finding cheaper stocks among the minnows.

Second, small caps don't suffer from the law of large numbers in the way that big companies do. It is far easier for a company like Virtus Health to double in size than it is for Westpac. Success with stocks like Sirtex, up almost 500% since 2010, and Hansen Technologies, which has risen 138% since our original recommendation on 29 Oct 14 (Buy – $1.52) prove the point. It's far harder for a huge business to grow 10%, let alone double in size. Elephants don't gallop.

The third advantage is more significant. Whilst successes like Hansen and Sirtex can have a big impact on our returns they mean nothing to big fund managers, who are handcuffed by size. They simply can't buy enough stock in a small cap to make a meaningful difference to returns without pushing the price up or launching a de facto takeover offer. Forced to chase top 20 stocks, the small cap pool has less competition, which favours more nimble retail investors.

Warren Buffett wistfully summed up the advantages of small portfolios, saying that, ‘the highest rates of return I've ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It's a huge structural advantage not to have a lot of money.' That last line in particular is something I frequently tell my wife.

Finally, the sheer variety of small caps offers the potential for genuine diversification in a way that large caps, particular in Australia, do not. With the ASX dominated by banks and resources, too many investors suffer from poor portfolio diversification. Small caps offer a way out of the conundrum.

None of this is to suggest that we're turning our backs on the country's biggest blue chips. Smaller stocks have their problems: share prices can be more volatile, although that can be turned to one's advantage; a well-established big business can ride out problems that might sink a smaller one; and with less scrutiny small cap management teams more readily give free rein to their incompetence and ego. Investing in this sector demands vigilance and deep analysis, the reward for which can be higher returns.

The time is right for a greater focus in this area, an enthusiasm tempered by our understanding of the risks. Past small cap recommendations like Servcorp, Gentrack, Hansen, ARB Corp and ALE Property, however, demonstrate that you don't have to slide down the quality curve in order to find value in smaller stocks.

Two new analysts

So we're delighted to have appointed two new analysts to expand our team to nine (or ten if you include me – they generally don't). One of the new analysts, Alex Hughes, will focus mostly on smaller companies, as will our existing analyst Jon Mills. We've also appointed a new junior analyst, Philip Bish.

As the year progresses you'll start to see more small company coverage to complement the research we provide in large and mid caps. You'll also see more coverage of collective investments, such as listed investment companies and exchange traded funds, courtesy of Mitchell Sneddon, who has joined the group via our acquisition of Eureka Report.

Eventually, we hope to launch a smaller companies equities portfolio and there's talk of making it investible, although we're not sure when that might be. The larger point is this: the opportunity to earn outsize returns is now better in smaller companies than elsewhere and we've expanded our analytical resources to ensure we get our fair share of these opportunities, plus a little more.

None of this affects our coverage elsewhere, which will continue. But our growing team of analysts delivers a capacity we haven't had before. We intend to make use of it, and we expect your portfolios to be the beneficiary.

Disclosure: The author owns shares in ARB, ASX and PMP.