Large and small-cap performance may converge
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While some recent star performers may be able to justify their multiples, the outperformance of small caps going forward is probably not going to be as great as it has been.
Australian large capitalisation stocks have struggled through 2016 following a bad year in 2015, and some experts believe that underperformance could diminish into 2017.
Over the past 12 months, the S&P/ASX Small Ordinaries Index is up around 27 per cent. In contrast, the S&P/ASX 200 is around 8 per cent higher. Falls in Telstra (ASX: TLS), the big miners and some of the larger banks are weighing down the index.
According to some experts, the difficulties facing large-cap stocks may well continue into 2017 as the two key sectors which dominate the top end of the market--resources and financials--continue to face challenges, while the share market overall is overvalued and at risk of correcting.
But small caps may also face their challenges, and their outperformance could diminish. Moreover, finding value in the sector is getting more difficult given the run up in prices.
"Small-cap shares have certainly had a terrific performance over the last two years and price-to-earnings ratios are very stretched, and these companies would need to continue to grow exponentially to justify some of the multiples out there," says Morningstar head of equities research Peter Warnes.
"Some will be able to achieve that but others won't and will get punished. I think the outperformance of small caps is probably not going to be as great as it has been and believe the performance of small and large companies will be more closely aligned.
"There will be probably be some good performances in some of the oversold bigger companies over the next year, such as Telstra and the big banks, though it won't necessarily happen straight away."
Warnes also says if the iron-ore price holds at around US$60 a tonne and if oil goes back to and holds at US$50, "we could see some good gains with some of the smaller resources stocks and energy shares, and the whole space could outperform".
However, a different view on the miners is held by David Bassanese, chief economist with ETF provider BetaShares, though he does say that over the medium term banks could turn around.
"For resource stocks, the lift in iron-ore prices over recent months seems unsustainable, and valuations have already priced in a lot of blue sky ahead," he says.
"Reduced net interest margins due to very low interest rates, slowing credit growth and ongoing concerns about the possible need to raise more capital could also continue to plague bank stocks."
However, Bassanese says "we may see global banks outperform in a rising rate environment even though global markets overall could struggle. Indeed, it may surprise some investors to know that rising short-term interest rates can in fact help profitability for some global banks, as it helps fatten net interest margins.
"It could continue to remain a stock-picker's market, therefore, where smaller-cap stocks with strong business models and demonstrated success in their niche areas of the economy could continue to do well.
"That said, finding value stocks--even in the small-cap sector--is becoming more difficult, meaning fund managers will need to work especially hard to get extra alpha from the market.
"Opportunities in the large-cap space may need to await a deeper correction in the market, the risk of which is building given high global equity valuations and the threat of higher interest rates in the United States over the coming year."
As for smaller caps, it's not time to switch off the whole sector, says Roger Montgomery, the founder and chief investment officer of Montgomery Investment Management.
Just because prices have run up for some small caps, it doesn't mean a company no longer represents "good value".
"It could still be 'cheap' if its value outstrips its share price rise. Take [software producer] Altium (ASX: ALU), for example, which just reported exceptional results for fiscal 2016, and forecast a very rosy fiscal 2017," Montgomery says.
"Altium's share price rocketed to an all-time high, but we think the company might still be one of the best value propositions on the ASX."
The company is a member of the S&P/ASX Small Ordinaries Index, though if its share price continues to gallop, it will quickly emerge into a mid-cap stock.
"We believe while the share price has risen to circa $9.50, we believe the intrinsic value has risen to more than $12.00. And when the overall market is expensive, rendering it difficult to uncover much value, talking a little about Altium might just be worthwhile," Montgomery says.
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Nicki Bourlioufas is a Morningstar contributor.
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