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Why investing shouldn't be exciting

Alex Milton  |  09 Dec 2019Text size  Decrease  Increase  |  
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Betting on an emerging Australian success story and its sometimes stratospheric early-stage share price gains is alluring for investors, but comes with a high risk of capital loss.

From NovaPort Capital’s perspective, managing the downside is just as important as finding growth opportunities when managing a portfolio of smaller companies.

Bubble, Bubble, froth then trouble!

Bubbles and fads often start and grow in the small end of the market. These can have a large distortion effect on the mix of companies that make up the Smaller Ordinaries index. These companies generally have market caps of between $500 million and $2 billion.

These sector dislocations or bubbles often reflect themes that are occurring in the broader economy.

An example is the growth of the small resource sector during the resource boom from 2003 -2010. This is demonstrated in the chart below. At its peak in 2010, small resources made up close to 50 per cent of the market weighted ASX Small Companies Index.

Industrial & resource exposure in Australia's small ordinaries index

small caps 1

Source: Bloomberg

Fast forward to today, and smaller technology companies are currently at their all-time high in terms of market weight.

The number of new listings on the ASX is dominated by technology companies. The chart below shows the effect of the growth in the market cap weight of the Small Cap Tech sector over the last eight years.

The bars show the growth in the weight in the index. The line indicates the forward valuation (P/E) ratio that the sector is trading on.

Not only has the technology sector valuation tripled, the exposure to these stocks has also increased. This has reduced recently to some degree due to a number of high-profile tech names, including WiseTech Global (ASX: WTC) and Appen (ASX: APX), graduating to the S&P/ASX 100 index.

S&P Small Ordinaries IT sector weight of the small ordinaries (left) and valuation (right)

small caps 2

Source: Style Analytics, Fidante Partners. Forward estimates calculated using IBES consensus data as at 31 July 2019

Avoiding trouble by ironing out bubbles

There are a few key ways to avoid these bubbles and dislocations in the smaller company market. These include:

  1. Assess and invest in the total return forecast not the relative return of each investment
  2. Invest in companies based on their profitability, not thematic concepts
  3. Invest in stable, high cash generative businesses.

It may seem like common sense, but using these rules can eliminate speculative companies from the mix and reduce the likelihood of favouring sectors over others.

The outcome is a more diversified portfolio of smaller companies that is generally less volatile than the market.

Although not as exciting, this approach tends to deliver superior long-term outcomes for investors.

The benefits of a conservative, less volatile approach

Using these techniques, an investing strategy can maximise opportunities and reduce losses during a downturn. This tilted return profile generally results in a smoother ride for investors without sacrificing longer term performance.

Smaller companies are cyclical, but over time companies supported by real earnings and supportive multiples are likely to recover. By growing off a higher capital base, any recovery is more likely to lead to outperformance in the longer run.

Along with the performance benefit, a less volatile approach reduces the risk of behavioural biases, such as loss aversion. By this, I mean the stronger fear most people have of losing money relative to their perceived benefits of making money.

Investors tend to panic during periods of large drawdowns. By reducing that downside by 40 per cent, this approach can reduce the urge to sell a position at the wrong time without allowing the market cycle to recover.

When is this approach most effective?

Such an approach doesn't outperform over the entire market cycle. The strategy is likely to underperform when large bubbles or fads occur, as outlined above, or at the later stages of a bull market.

The time in the cycle when this approach is likely to outperform other smaller company portfolios is when markets fall, and then subsequently rebound.

Managing a portfolio conservatively and consistently is far more important than being part of the next big thing.

is portfolio manager with asset manager NovaPort Capital.

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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