Small caps to maintain momentum into 2018
As always, the ability of fund managers to find the future growth shares and avoid the big underperformers will be key.
This year small-cap shares have once again outperformed their large-cap peers based on the performance of the S&P/ASX Small Ordinaries Index and some experts expect that outperformance to continue into 2018.
Over the year to 30 November, the S&P/ASX Small Ordinaries Index was up by 20.5 per cent, compared to 14.6 per cent for the S&P/ASX 200, which measures the performance of larger companies.
While there is no guarantee that small-caps will do the same in 2018, some analysts say small caps have a good chance of outperforming the broader share market next year.
"Small-cap companies really played catch up in the August reporting season and have run very strongly since then," says Ross Macmillan, senior analyst, manager research, at Morningstar Australasia.
"We anticipate that continuing into 2018, small caps will continue to perform well, though perhaps not as strongly as they have been during the last four months, but definitely they will keep going.
"Capital investment and business confidence are both picking up and that will be good for small-cap stocks, which are more exposed to the domestic economy. While economic growth is benign at between 2 per cent to 3 per cent, it looks like interest rates are going to be on hold for much of next year, if not the whole year."
Andrew Smith, head of smaller companies and micro caps with Perennial Value Management, says after several years of underperformance, investors were initially attracted to the better valuations for small caps.
"However, much of that value has now gone," he says. "More recently, there has been a noticeable improvement in risk appetite. This has added fuel to the rally with investors taking comfort from the almost synchronised growth that is occurring around the world."
"Finally, investors have responded to slower growth in traditional large-cap sectors such as banks and telcos and have begun searching the small-cap market to access higher-growth sectors such as the Chinese consumer-exposed names and small resources."
Smith isn't so confident of a rally at an index level in 2018, "given the elevated valuation of the stocks that make up the top 20 of the S&P/ASX Small Ordinaries Index--these have driven most of the returns this year," he says.
"However, we see good prospects for many of the 'value' small caps which we own--these stocks tend to be outside the S&P/ASX Small Ordinaries Index and under the radar of most investors."
Smith finds healthcare attractive "given defensive earnings and reduced government regulatory risk. Integrated Diagnostics (under takeover) is a key holding as is independent medical device distributor Lifehealthcare (ASX: LHC)."
He also names retirement home builder Gateway Lifestyle Group (ASX: GTY) as potentially attractive, as its earnings stream, rent from retirement housing, is defensive and growing.
Apart from a2 Milk, which has risen just over 200 per cent over the past year, there are several small-cap companies across the industrial sector that Morningstar's Macmillan expects to do well next year, "including the small-cap miners, "particularly in iron ore, gold and lithium, and that is an area that will likely continue to do well in 2018".
"There is a lot of technological disruption out there, where small-cap companies such as the recently listed Netwealth (ASX: NWL) are adopting new technology and running at very low costs.
"You can apply this formula across different industries, where small caps are really taking advantage of technological development and disruption and reducing their costs and giving the larger incumbents a run for their money."
Looking forward, the main challenge for small-cap investors in 2018 will be Australia's relatively low-growth environment. The performance of small caps is closely tied to economic growth, as growth opportunities are linked to the economy's expansion.
So, any downgrade to domestic growth would be a negative, says Perennial's Smith.
But Macmillan expects the Chinese economy to continue to grow and avoid a hard landing, which will favour Australia's own economic growth.
As always, though, the ability of fund managers to find the future growth shares and avoid the big underperformers will be key. Analysts say there is a greater role for active management with small caps than large caps, as smaller stocks are less well known and require more research from a skilled fund manager to avoid the losers.
Macmillan says the Gold-rated BT Wholesale Smaller Companies  and Silver-rated Fidelity Future Leaders  funds "are both well regarded by Morningstar".
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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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