Nicholas Grove: I'm Nick Grove for Morningstar.com.au and today I'm joined by Morningstar fund research manager Tom Whitelaw. Tom thanks very much for your time today.
Tom Whitelaw: Hi Nick. Thanks for having me.
Grove: First of all, Tom, you recently caught up with several small-cap shops that fall under your research coverage. What was the general mood among these managers and in which areas are they seeing value?
Whitelaw: Yeah. So, we've just finished our Australian small-cap review. So, we're covering around 40 managers. So, we've really got a good overview of what's going on in the market. I'd say, there's definitely more bulls than there are bears out there. I think that's just driven by valuations at the minute.
So, we've seen kind of the re-rating of a lot of these stocks that have kind of moved up through historical high points and I think a lot of managers are now kind of having a little look and feel and thinking the market looks expensive, but where do they go. So, while value might be drying up in the industrials side, there's still a bit up uncertainty in the resources side. So, people aren't really wanting to look there, and there's also a number of managers who sold maybe a little bit too early, so this run has probably gone further than some might have expected, and they felt a little bit of pain from that.
So, yeah, we've seen a lot of small-cap stocks running up into the top 100 and into the top 50, which has caused a number of the small-cap managers who are true to process and style having to sell. So, there's some cash out there, and we've seen the IPOs coming where they've taken advantage of a few of those to kind of diversify a little.
Grove: Locally, Tom, we've seen a bit of a surge in the number of IPOs. We've seen Spotless comeback on to the boards and we'll soon see Healthscope do the same. What do these managers think of the recent run of IPOs?
Whitelaw: Yeah, I think broadly they are pretty pleased. Like, I say, they're really looking for new opportunities. So, the small-cap market's been fairly concentrated in a number of specific sectors, so it's provided quite a lot of diversity, some new opportunities for people to look at, but it's been quite difficult, I think, for a lot of managers to get access to some of these IPOs. So, if fund managers are finding it difficult, certainly the individual investor's finding it almost impossible. If anything's any good, it's gone from the outset.
I think they've also struggled to get the time, because there have been so many. We've seen how many have been launched in the last 12 months. It's been pretty astronomical. So, I think managers are struggling with the time, just to sit down and read a full prospectus, and managers that we really like are those who want to spend a lot of time, go kick the tires and really read through the prospectus and understand the business. A lot of times, they haven't had the time on some of these IPOs, so some of them have been left alone, and even if you do find a good one that you really like, it's often difficult to get filled in the size that you want. So you might ask for a decent chunk but get really scaled back quite a lot and we've seen the huge tick ups on day one, so it's not really given people opportunities in the secondary market because although the quality has been there, valuations have been high, and they've been going higher as they've been listing.
Grove: Tom, with the Australian economy transitioning away from the resources sector, are the small-cap managers you've spoken to also moving away from this space or do they see it as an area that's ripe with opportunity?
Whitelaw: Yeah, I think it's a really difficult time now. It's kind of at a balancing point. So, we'll really see, the reporting season that's coming up, will probably shed a lot of light on if earnings are being hit and kind of how much margin pressure there really is out there. So, we've probably seen over the last few years, the weight of resources in the small-cap index, fall from about 40 per cent, probably halve down to about 20 per cent now, and that's due to, as we've seen the falling prices as we've talked about.
So, they are seeing an opportunity there, but a very small set of managers are seeing an opportunity there. I think a lot are still biding their time, because we're really just waiting to see a kind of 50-year bull run in the resources sector and the mining sectors. So, there's a danger that some of these guys could burn themselves to the ground, kind of fighting for the last scraps out there, but I mean, the market's going to recover at some point, and it's really just finding that time, they don't want to buy too early, because again, as we've talked about before, managers sold out of some of these industrials that ran too early, some also moved into some of these resources that have continued to fall, so there's a bit of nervousness about.
Grove: Finally, Tom, what are the main qualities that investors should look for in a manager if they're seeking to increase their small-cap exposure?
Whitelaw: Sure. I mean, a Morningstar Medalist is a great way to start. Of course, I'm going to say that, but our Gold, Silver and Bronze managers, I mean, we really do spend a lot of time kind of really getting in there and really understanding the strategy and understanding the people behind it. So, it's kind of our "five-P" process, so people are really important down at small caps. So, you want really engaged investors who are very experienced and have known these companies for a long time and you want a process that plays to their strength. So if these guys are really inquisitive and want to go out there and kick the tires, you want to make sure that that process allows that -- kind of understanding the valuation tilts within the process and where it may or may not work. Then we kind of move through to the parent organization -- so, are they working, are these fund managers themselves working for a company who allows them to play to their skills and not kind of dragging them off everywhere, if they're a successful small-cap manager trying to get into in a large-cap product, for example.
And price is also important, especially with the benchmark structured as it is, and we've seen how easy it's been for a lot of these managers to beat their benchmark over the last few years. If they've got a performance fee component there and it isn't really interlinked with the benchmark and what they're trying to do, you can get some very high fees. So, you want to be careful, that investors are getting what they're paying for essentially.
Then the final point is performance and it's something we'll always uses as a sense check, so we might go through the first four Ps, thinking they're absolutely brilliant, then look at the performance and it's been terrible. So, we kind of go back to square one and kind of have a look and make sure we've not missed anything. So, yeah, if you want a good small-cap manager checkout our Medalist-rated funds.
Grove: Tom thanks very much for your time today.
Whitelaw: Great. Thanks a lot, Nick.