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Are small caps staging a comeback?

Nicki Bourlioufas  |  30 Sep 2019Text size  Decrease  Increase  |  
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Small capitalisation companies could outperform in the coming year, despite the category's poor fiscal 2019 reporting season and ongoing volatility that has knocked share prices.

But lower interest rates and an improving economic outlook for Australia could turn that around, say several asset managers.

Over the past year, small caps – which in Australia are generally listed companies that sit outside the ASX 100, with market caps of between $100 million and $2 billion – have performed poorly compared to the overall share market benchmark.

The ASX/Small Ordinaries Index provides one way of identifying such companies, consisting of 200 companies that mostly meet the above criteria, accounting for around 7 per cent of Australia's total share market capitalisation.

The Small Ordinaries index has gained just 4.4 per cent, while the S&P/ASX 200 is up 12.6 per cent over the year to 26 September. Large companies have led the gains, with the S&P/ASX 50 jumping 15.4 per cent over the year to date.

Most of the companies for which Morningstar Australia provides research coverage are either mid- or large cap securities, with only around 26 occupying the middle ground between the ASX 100 and ASX 300.

Of these, only seven are awarded Morningstar economic moats:

And the share prices of only three – neither of which have moats – are regarded as undervalued by Morningstar equity analysts, as at 2pm on Monday 30 September:

But research from investment bank UBS suggests small caps are set to outperform. UBS modelling indicates the level of the price-to-earnings (P/E) discount today means that small caps - as measured by the Small Ordinaries Industrial Index – could outperform large caps (or the S&P/ ASX 100 ex financials) by around 3 per cent over the next year.

During reporting season, the typical industrial small cap in the ASX 100 to 200 experienced a 0.4 per cent drop in its share price after its result compared to the overall market, in contrast to the large caps, where companies that reported bounced 0.6 per cent more than the market.

“This has seen the P/E discount of the small caps rise to the highest since 2012,” say UBS analysts Pieter Stoltz, Paul Winter and Jim Xu in a recent research note.

They believe small cap stocks with higher PE discounts will outperform over the next 12 months.

Housing, rates paint brighter picture

Jun Bei Liu, a portfolio manager from Tribeca Investment Partners, agrees that with the Australian economy stabilising, helped by lower interest rates, small cap stocks will perform strongly over the next 12 months.

She says they have a lot more upside than large caps, which have already rallied hard this year.

“Normally, when you get a risk-off environment during a period of market volatility like we’ve had this year, people tend to sell small cap stocks and move into large caps, which have more established businesses and their earnings are more defensive.

"This is what has happened this year, so we have seen large caps outperform and small caps underperform," Liu says.

But she suggests the combination of two interest rate cuts this year and the potential of more to come; improving house prices; and a more stable economy will create a good environment for small cap outperformance.

Liu points to mining services company Emeco Holdings as potentially outperforming, suggesting it is not currently widely followed by investors because it is ex-ASX 200.

But compared to its more expensive peer, Seven Group (ASX: SVW) “you'll get the same amount of growth from it, or more, and pay half the price for it.”

Proceed with caution

However, UBS analysts are cautious on how overweight investors should go in small caps. 

“In contrast to other markets, small caps have tended to underperform large caps in Australia due to oligopolies dominating. This historical underperformance justifies a lower relative P/E multiple for the Small Industrials,” they say.

“While our model suggests the small caps could outperform, we don't advocate a naïve overweight position. We combine screens with analyst insights to identify potential overweights in Appen, Imdex, Myer, Nanosonics and NRW Holdings.

“We think GUD Holdings (ASX: GUD), Japara Health Care, Mayne Pharma (ASX: MYX) and SpeedCast are potential underweights.”

Both part of Morningstar's equity research universe, GUD is an automotive parts company and Mayne is a specialty pharmaceutical company.

They are three-star stocks, with respective fair values of $11 and 55 cents – roughly in line with their most recent share prices.

Sam Twidale, portfolio manager of the DNR Capital Emerging Companies Fund, says his fund is overweight the information technology sector, “where we see a number of high-quality businesses benefiting from the structural tailwinds of rising information technology investment and the emergence of new disruptive technologies.”

He also is overweight financials, where he expects disruptive business models to take market share from established market players, and likes exporters.

"We like investing in strong domestic businesses that are expanding organically into significantly larger global markets," Twidale says.

Clime Asset Management’s small caps portfolio manager Jonathan Wilson believes it is difficult to say whether the small cap indices will outperform in the year ahead. "However, it is our strong view that good selection within the smaller company space will yield superior results.”

A key focus of the fund is on niche leaders “that have secular growth tailwinds, and we see plenty of opportunity outside the major indices."

"We’re particularly excited by the global opportunities available to Auindate, Lovisa, RPMGlobal, IMF Bentham and Electro Optic Systems.

"Closer to home, we also see long term secular growth from domestic-demand businesses like Integral Diagnostics and Macquarie Telecom.”

 

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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