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Risks and rewards of micro-cap funds

Glenn Freeman  |  20 Feb 2018Text size  Decrease  Increase  |  
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Traditional small-cap equities managers are increasingly stepping into the micro-cap space, which was a surprising theme of 2017, according to the Australian Equities Sector Wrap compiled by Morningstar directors of manager research, Chris Douglas and Tim Murphy.

Eley Griffiths Group, Perennial Value, Wilson Asset Management and Bennelong Australian Equities Partners are all examples.

Douglas and Murphy note that this has traditionally been a niche area of the market, with only three strategies within Morningstar's coverage having a track record of more than 10 years: CFS Wholesale Developing Companies (11321), Novaport Microcap (12350) and BT Wholesale Microcap Opportunities (14320).

New launches in the space are driven by the following factors:

  • managers' existing small-cap strategies reaching capacity
  • the appeal of high micro-cap fees for managers
  • potential synergies between micro- and small-cap strategies.
  • "Investors should approach these strategies with great care, and consider at most a satellite allocation within a more broadly diversified allocation to Australian equities.

"Importantly, we’d highlight that the launch of new micro-cap strategies by existing small-cap managers has the potential to distract from their core small-cap offerings. How managers resource new strategy launches is an ongoing key watch point for Morningstar," according to Douglas and Murphy.

What's a micro-cap?

With various definitions of a micro-cap company, Morningstar defines the micro-cap segment as comprising the bottom 3 per cent of the Australian market by capitalisation, or companies with a market cap up to $300 million.

Though ondividual managers some flexibility to invest further up the spectrum (see Exhibit 1), in general, a micro-cap manager will invest a large proportion of their portfolio at the very small end of the market. This presents both opportunities and challenges.

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Exhibit 1 Ownership analysis of CFS WS Developing Companies and Ausbil Micro-Cap


chart


Source: Adviser Research Centre. Data as of 30/09/2017

 

Contrarian appeal

Their position within an under-researched segment of the market is one of the main attractions of micro-caps. "These stocks are either too small, too new, or indeed too speculative to be on the radar of many stockbrokers or institutional investors," say Douglas and Murphy.

Managers within this space succeed or fail based on their ability to identify "undiscovered gems" that have the potential to grow earnings and eventually migrate toward Small Ordinaries--which comprises companies within the S&P/ASX 300 but outside the ASX 100.
Within the S&P/ASX 200, from which the majority of companies covered by Morningstar's equity research team are drawn, there are numerous examples of former micro-cap companies that have flourished into large-caps.

TPG Telecom (ASX: TPG), launched as SP Telecommunications with a market cap of just $22 million in 2001, it's now a top-100 company.

"More recent examples include Webjet (ASX: WEB) and Blackmores (ASX: BKL), which have grown from relative obscurity to being solid S&P/ASX 200 companies."

The considerable challenge lies in understanding, monitoring and accounting for the risks such companies pose in the early stages of development--which take considerable time and effort for companies with untested business models and with often scant financial histories and unproven management.

"Early stage micro-caps with immature business models can be cash hungry, and reliant on regular capital raisings to fund growth.

In the event of a ‘risk-off’ event, equity market liquidity can dry up quickly, leaving micro-caps vulnerable, say Douglas and Murphy.

This lack of liquidity can also mean difficulty exiting positions during times of market stress. The micro-caps composite series fell by 51.8 per cent in 2008 during the global financial crisis, compared with a 38.4 per cent decline in the S&P/ASX 200 Accumulation Index, highlighting the risk in the sector.

The fee structure in microcaps is also highly attractive to managers, with base fees ranging between 1.2 per cent and 1.8 per cent, plus performance fees."This reflects the capacity constraints in the sector and the detailed investment necessary, with $300 million to $400 million seen as the upper end of assets that can be reasonably managed, and a lack of available research from third parties, such as stock brokers," say Douglas and Murphy.

"By its nature, micro-cap investing tends to be more resource- and time-intensive. In this respect we highlight the risk that managers run in over-stretching themselves with new strategy launches.

"Overall, as long as market conditions remain reasonably buoyant, we are likely to see the trend of microcap launches continue. However, investors should exercise caution, and there are numerous risks, particularly given where we are in the current investment cycle."

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Glenn Freeman is a senior editor at Morningstar.

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