Global headwinds buffet small caps
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Philippa Yelland is a journalist with InvestorDaily, a Morningstar publication.
The small-caps universe continues to challenge fund managers, for reasons of global macro events and rigorous screening processes to ensure returns to investors.
Avoca Investment Management managing director and portfolio manager John Campbell said global macro events affected Australian small caps more than large, because small caps tended to be more economically cyclical than the top 100 stocks.
Campbell said the small-caps universe was more economically cyclical "largely due to a heavy composition of resource stocks within the small-caps benchmark (36 per cent for the S&P/ASX Small Ordinaries Index versus 22 per cent for the S&P/ASX 100)".
Small resource stocks had underperformed small industrial stocks by over 40 per cent since January last year. For example, the Bennelong-owned Avoca Emerging Leaders Fund  has been well underweight small resource stocks and continued to be so.
"That said, with small resource stock valuations looking more attractive than at any point over the past year, the case for a large underweight is diminishing," he said.
Not surprisingly, investors remained highly risk-averse due to the unknown endgame in Europe. Negative growth across the eurozone for the next few years was the most likely outcome.
"The question as to whether this will lead to weaker growth across the US and Asia remains unanswered, and will certainly haunt the 2012-2013 financial year and impact the Australian investment landscape," Campbell said.
Schroders was moving away from defensives towards cyclicals through eliminating risky cyclical stocks and then looking at what remained, the company's senior portfolio manager smaller companies David Wanis said.
"This process of elimination reduces the opportunity set for investment within the small companies market and we continue to apply our research effort to uncover the best risk-return opportunities from within this group," he said.
Wanis said it was Schroders' approach to look at which cyclical stocks to avoid and then look at what remained.
"An improvement in cyclical conditions can result in short-term share price gains. However, for the longer-term investor, the structural pressure continues to undermine returns. Examples include industries such as media and discretionary retail," he said.
Thematic risks surrounded resource companies and their service industries. Many of the biggest underperformers in the past year were in resource companies (mining and energy) or resources' services.
"However, our concern in assuming value has emerged in that, under our long-term commodity price assumptions, many of the mining companies fail to warrant any positive equity value. When the market has priced in a 15 per cent decline in mining services earnings but a highly probable scenario is a 50 per cent decline, value is not apparent," he said.
Balance sheet risks were apparent in the financial leverage many small and large companies continued to carry.
"Given we do not profess to have an edge in short-term timing," Wanis said.
"We prefer to invest in companies that have sufficient balance sheet capacity to protect equity if a recovery in operating conditions takes longer than many expect. The quantum of this capacity in our view should be measured in years, not quarters."
Quality risks were stocks that did not have structural, thematic or balance sheet risks, but were low-quality value traps. These were businesses that had no identifiable competitive advantage, and no way to sustain excess returns on capital in the long run.
Multiple-risk stocks have a combination of risks: low quality, and being excessively geared and structurally challenged.
"Buying a stock that gives not one but two or three ways of losing investors' money is not the best idea to put money into," Wanis said.