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The return of the ASX big caps

Anthony Fensom  |  13 Apr 2017Text size  Decrease  Increase  |  

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Large-cap ASX stocks outperformed their small-cap counterparts over the past year but whether the outperformance continues will depend on the banking sector and the major miners.


"Big-cap" stocks are back in favour with investors again after previously lagging their smaller rivals.

Small-cap stocks, as measured by the S&P/ASX Small Ordinaries Index, posted a 1.18 per cent gain over the year to 10 April 2017, as compared to a 4.36 per cent rise by the S&P/ASX 200 index.

The top 20 stocks have reflected this performance, rising by 3.9 per cent.

"Large-cap fund managers have been investing in smaller companies the last few years because their traditional holdings were looking a bit soggy," Victor Gomes, portfolio manager of the UBS small-cap fund, told The Australian Financial Review.

"This earnings season we've probably seen a bit of a reversal of that trend, especially as those managers realise the rewards lie for those who are picking the correct stocks."

Previous small-cap favourites such as the China-focused Bellamy's Australia (ASX: BAL) virtually halved in December on fears the "white gold" dairy export boom was finished.

Others, such as fintech company OFX Group (ASX: OFX), have felt investors' wrath over unexpected earnings downgrades.

Value returns

Morningstar's head of equities research, Peter Warnes, traces the return of value to the big caps back to mid-2016.

"If you go back to around July last year, the big caps were under the whip with the banking sector fallout. There was fundamental evidence that some value was coming back into the market," he said.

"That's when you saw managers like Wilson Asset Management's Geoff Wilson, who had been ignoring the large caps, to instead raise $330 million to invest solely in the top 20."

Warnes said the banking sector, which represents around 30 per cent of the ASX, had "dodged a lot of bullets," helping the return of the big-cap sector, although he pointed to "disappointments" in earnings such as AMP (ASX: AMP), Brambles (ASX: BXB) and Telstra (ASX: TLS).

Healthcare, telcos favoured

Morningstar's current large-cap favourites include healthcare and telecommunications stocks, with the former comprising private hospital operator Ramsay Health Care (ASX: RHC) and private pathology company Sonic Healthcare (ASX: SHL).

Narrow-moat-rated Ramsay was described by Morningstar analyst Chris Kallos as "significantly undervalued" as of 31 March, having seen its share price slip on a cautious trading update from rival Healthscope (ASX: HSO).

Kallos considers the company to have a sustainable competitive advantage due to the scale of its network in Australia and overseas, together with its pipeline of brownfield projects and recent move into community pharmacy.

Similarly, the narrow moat-rated Sonic Healthcare is seen benefitting from its international revenues, reducing its vulnerability to any changes in government funding in Australia, where it has a 40 per cent share of the private pathology testing market.

In the telco sector, Morningstar analyst Brian Han notes the "series of adverse developments since September" that have seen shares in narrow-moat-rated Vocus Group (ASX: VOC) trade well below "fair value".

Board ructions over its merger with M2 and Nextgen have been resolved, while the company continues to generate "solid organic growth," especially in the corporate sector.

Han also believes the impact of the National Broadband Network on Vocus will be relatively limited, with the NBN rollout actually helping it to increase market share.

Among smaller-cap stocks, Warnes pointed to veterinary chain Greencross (ASX: GXL) along with Nine Entertainment (ASX: NEC), albeit with a lack of any moat protection for either company, given the lack of barriers to entry in the vet industry and the media sector's growing fragmentation.

With bond yields now easing back after their surge in late 2016, Warnes suggested so-called "bond proxies" such as Sydney Airport (ASX: SYD) and Transurban Group (ASX: TCL) were also making a comeback, aided by their reliable cash flows.

Can the small-cap stocks bounce back? Recent gains in commodity prices, such as coal and iron ore, have supported a revival in the resource sector that contains a multitude of small-cap explorers.

According to BDO, industry confidence is improving with exploration expenditure having risen in Australia for four consecutive quarters. An increase in initial public offerings (IPOs) and merger and acquisition activity is expected for the resource sector in 2017.

However, whether the big caps outperform their smaller rivals will depend on the sustained performance of the banking sector and the major miners.

Unlike the small caps, the larger, blue-chip companies typically provide investors with the comfort of regular dividends, although the less scrutinized smaller stocks can offer the potential for larger capital gains for those willing to do their homework.

In this regard, Morningstar's research of small and large-cap funds spanning a range of sectors and investment styles could prove a useful starting point.

After all, today's small cap could be tomorrow's big cap, as demonstrated in the past by some of Australia's largest companies.

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Anthony Fensom is a Morningstar contributor. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria. The author does not have an interest in the securities disclosed in this report.

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