Small cap stocks: 'Inevitably, we see it all end in tears'

<p><strong>Glenn Freeman: </strong>Welcome to another edition of "Ask the Expert." We're talking small cap funds. I'm joined today by Ross Macmillan from our manager research team.</p> <p>Ross, you've been conducting some reviews of the small cap managers in Australia and New Zealand.</p> <p><strong>Ross MacMillan:</strong> Thank you, Glenn. Yes, we cover about 30 to 35 small cap fund managers in the Australian market.</p> <p><strong>Freeman: </strong>Just to start off with, what's your definition or what's Morningstar's definition of a small cap stock?</p> <p><strong>MacMillan: </strong>Traditionally, most institutions say that any company that is outside the ASX 100 but down to the ASX 300, so about 200 companies, is a small cap stock and one that they consider and look quite closely at. At Morningstar, we take a much broader view of what's a small cap stock. We say anything that's outside the ASX 100 down to anything like a company that has a market capitalisation of $250 million, anything beyond that's a micro-cap stock. So, importantly, when we are judging the performance of our small cap fund managers, we benchmark them against the small ordinaries index.</p> <p><strong>Freeman: </strong>Obviously, coronavirus is the theme that's really dominating markets and discussions at the moment. How did small cap funds hold up during the sell-off? And I was just looking at some figures earlier and just the dive that small cap funds took was a lot more pronounced, but I think they've actually bounced back harder, haven't they?</p> <p><strong>MacMillan: </strong>Yeah. So, I think what you've got to remember is that small caps are traditionally and historically more volatile. I can remember as far back as the '87 crash, the tech crash&hellip;</p> <p><strong>Freeman: </strong>You're not that old surely, Ross.</p> <p><strong>MacMillan: </strong>Yes, indeed, I'm afraid so. And I can remember in the Global Financial Crisis as well. Now, if we look as well as now the pandemic crash and bounce back, if we go back to Global Financial Crisis, in the lead up to that event, small caps outperformed very strongly. It was a best-performing asset class for four years. Indeed, in the year before the Global Financial Crisis small cap stocks were up 44 per cent. But in the next two years, in each one of the next two years, they fell off by over 20 per cent. And look, in the lead up to this recent pandemic crash which has been an absolutely tragic event, we saw small caps once again outperforming. In 2019, in the calendar year 2019, small cap stocks were up something like 27 per cent. And yes, they have during the crash fallen quite heavily and more than the large cap stocks. But the bounce back has been extraordinary. We've seen small cap stocks really rebound. It's almost becoming a bubble, I would say, Glenn.</p> <p><strong>Freeman: </strong>We've heard a lot about the younger day traders who have been pumping up the volumes of share trading, particularly among some of these small cap and earlier-stage companies. Is this something that you've seen play out within the small cap fund space?</p> <p><strong>MacMillan: </strong>Yeah, indeed, there's a huge amount of retail money coming into the market at the moment. Most of that retail money is going after the small cap stocks. The new concepts of stocks that are in particularly hot sectors and it's almost self-perpetuating. The money is coming in. It's going into the less liquid stocks. It's pushing up the share price. There's momentum. Further retail money comes in and chases up these stocks higher and higher. Unfortunately, some of these companies have got very limited earnings. So, on a P/E ratio these stocks have been pushed up to 50, 60, 70 times their earnings, which when stocks get to that sort of level, inevitably we see it all end in tears. We've seen this in 2000 with the tech bubble and then crash. And undoubtedly, this will occur again. And because of that we're seeing a lot of the small cap fund managers go into stocks and happy to sell into all this retail money that's probably less sophisticated than they are. Many of the portfolio managers that are running these small cap strategies have been in the market for long time. They've seen these sorts of things occur. They do a lot of work on the companies that they do invest in. So, when their valuation mark is reached, they are happy to sell. They're not going to continually chase stocks higher and higher like the retail money is. So, certainly, a concern for those retail investors what's occurring at the moment. And I'd recommend caution.</p> <p><strong>Freeman: </strong>And just finally, Ross, I mean, is there enough diversity among the small cap funds that are on offer in Australia or should investors really be looking further afield at some of the global small cap funds?</p> <p><strong>MacMillan: </strong>Well, certainly, the Australian market is small. We're a population of 25 million and we have some very&mdash;some of the sectors in our market are very limited, number of stocks are very limited. Certainly, a wise investor would consider not just investing in large cap and small cap stocks in Australia but globally. Certainly, it would be wise to diversify, have a large cap fund manager for your global stocks but also a manager that invests in small cap stocks globally. It gives you access to huge amount of different economies. It gives you access to huge amount of different sectors in the areas of technology particularly.</p>