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Small caps may soon outperform

Nicki Bourlioufas  |  04 Oct 2017Text size  Decrease  Increase  |  
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Fund manager Allan Gray says that after a long period of underperformance, small caps could soon be outperforming large caps, but other analysts say the weaker domestic economy means the recovery could be mixed across sectors, so stock-picking is therefore required.


Allan Gray chief investment officer Simon Mawhinney says the small-cap sector has long been underperforming large cap stocks but low valuations are likely to attract investors.

Despite small caps having rebounded a little from their 2015 lows, the sector "has significantly underperformed over the past 20 years and has underperformed the top 100 by 7 per cent in the 2017 financial year alone [to June 30]," says Mawhinney.

"We believe the significant underperformance of this sector to be temporary," he says. "The smaller end of town is still much cheaper than the large end of town, and in particular, the small end of town is cheaper than the big banks."

However, small and micro-cap portfolio manager with Perennial Value Management, Andrew Smith, says the performance of small caps is linked to the strength of the Australian economy, which has been growing below trend. He isn't as confident about a broad-based small-cap outperformance as Mawhinney, but he does see growth for tourism, mining, and mining services.

"While there has been a catch-up in recent months, large caps are still outperforming small caps on a one-year basis. Indeed, the recent catch up has entirely been driven by small resources as small industrials are still lagging," he says.

"The missing ingredient to see small caps fully catch up is small industrials performance and for that we need a strong domestic economy. The jury is still out here."

Smith believes a higher Australian dollar could help. "This correlation [between a higher Australian dollar and small-cap outperformance] makes sense as it typically means commodity prices are higher, so small mining stocks are stronger and domestic economic conditions are beginning to improve," Smith says.

He prefers exposure to growing sectors such as tourism "and those stocks exposed to the strong pipeline of infrastructure projects as well as the recovering mining and mining services sector. In contrast, we are cautious on retail and housing stocks."

Mawhinney sees the greatest opportunities outside the largest 100 shares in the S&P/ASX 300 Accumulation Index. For example, he sees an attractive investment opportunity in PMP Limited (ASX: PMP).

"PMP is priced at a level significantly below that of the broader share market. On the face of it, this is a rare opportunity and it is reasonable to ask how we might be wrong," he says.

"We understand there to be three areas of concern. The first is that the projected synergies from the IPMG merger will prove elusive ... The second concern is that the irrational behaviour of the print industry over the past 15 years may not be over and significant competitive tension between the now top two players may be every bit as damaging as the five large players over the recent past. And lastly, that cyclical and structural headwinds may inhibit the company's ability to deliver its targets.

"All of these concerns have merit and create an element of uncertainty but we believe this has been more than reasonably reflected in the share price."

Perennial's Smith highlights two attractive small-cap opportunities. The first is Gateway Lifestyle (ASX: GTY), which offers defensive growth from its annuity-like retirement earnings. After a rough patch since the IPO, the new chief financial officer and broader management team have got corporate costs under control and rents keep rising, Smith says.

Another stock the team likes is RPM Global (ASX: RUL), which is valued like a typical mining services company despite being a software provider to the sector.

"As a result, you get the great aspects of a software company--high margins and recurring maintenance fees--at a significantly lower multiple," says Smith.

Mawhinney isn't sure of the reasons for the small-cap underperformance, but says it could be due to the strong growth of ETF investing.

"It has been argued that this underperformance is the result of a shift to passive and ETF investing, where it is possible to replicate 87 per cent of a market's exposure with the top 100 share positions. It's not clear--this shift to passive investing is a global phenomenon but it hasn't resulted in similar underperformance of small capitalisation stocks in other large developed share markets," says Mawhinney.

"More important than identifying the reasons behind the pendulum's shift is determining whether it is permanent or whether it will return to its swing path. We believe the significant underperformance of this sector to be temporary."

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Nicki Bourlioufas 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.

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