Small caps ready for take-off

ALL share investors were hammered in the summer of 2007-2008, but investors in small-cap stocks were particularly hard-hit.

Blurry ASX screen /File

Small caps ready for take-off

ALL stock-market investors have been hammered in the summer of 2007-2008, but investors in small-cap stocks have been particularly hard-hit.

Where the S&P/ASX 200 Index lost 15.7 per cent in the three months to the end of January, the S&P/ASX Small Ordinaries (which comprises companies ranked 101 to 300 in market capitalisation) lost 19.6 per cent.

The villains of the piece were the financial-related stocks perceived to be carrying high levels of debt, which were savaged on the back of the wave of risk aversion that swept global financial markets over the Australian summer.

This group featured the likes of Allco Finance Group (down 95 per cent from its peak), Credit Corp (down 94 per cent), City Pacific (down 82 per cent), MFS (down 81 per cent) and ABC Learning Centres (down 80 per cent).

"When a stock you own loses 80 per cent, that's going to hurt your numbers, even if it's only a small part of the portfolio,'' says David Smythe, director of Zenith Investment Partners. "If you own two or three such stocks, that's real pain.''

Indiscriminate falls

But the carnage was not confined to the financial-related stocks. Small-cap fund managers watched in horror as even their soundest businesses took 20-30 per cent hits on the market, gapping (falling very sharply with no trades occurring at the price points in between) all over the place.

"The whole market took a hit in January, but the small-cap managers were hit harder,'' says Anthony Serhan, head of research at Morningstar. The market was down 14 per cent, but there was catastrophic gapping in some of the small-cap stocks.

"That simply tells you that you're dealing in small caps, where the liquidity might not be there in an extreme market situation.

"Just as people no longer take liquidity for granted when they talk about interest-rate securities, the same is true for small caps.

"The fact is that the small caps are often less diversified or are single-product businesses.''
Lin Ngin, senior investment analyst at Lonsec, says it has been "an uncomfortable experience'' for many small-cap managers that what they may have thought to be a naturally defensive exposure -- the financial stocks - has been "the most bashed''.

"That's what's been a bit different this time around,'' he says.

Nigel Douglas, head of research at van Eyk, says small-cap stocks are "unavoidably high-beta'' (that is, show a high correlation to the movement of the market index).

"Small-caps tend to rise faster and fall faster than large-caps, but when the market sells off, there tends to be a flight to low-beta stocks.

"That's before you even look at the stock-specific factors that hit a number of the small-caps very hard.''

Mr Douglas says investors should remember that the small-cap stocks - particularly the resources component - had "run pretty hard when the economy was strong'', and are now only giving some of that performance back.

In vain the managers complained that the initial market selling was indiscriminate, and that good-quality stocks were hit hardest, as market participants searched for liquidity.

"We're now in a period of rising interest rates domestically, and that's when you tend to get under-performance from small caps,'' he says.

"That's normally what you find in a market slump,'' says Greg Barr, director of fund services at Standard & Poor's.

"People are trying to exit the market, the large caps get sold off first, because they're more liquid, and then the better-quality small caps get sold off because they have the liquidity.

"In the last three months we've seen this effect in a number of asset classes.

"In this kind of situation the small caps can suffer a longer-running effect, but there are a number of factors that should enable the better-quality small caps to rebound.

"The first is that the value-oriented small-cap managers will come in to buy up the stocks that have been oversold, and secondly, the advantage that some of the small-cap stocks have is that they are generally more Australian-focused.

"The Australian economy is still growing much better than other developed economies, and looks to have better growth prospects.

"That hometown bias is going to help those small caps, versus the more diversified large caps, which tend to be more exposed to the global economy.''

February rebound

Mr Serhan says it is "fascinating'' that the small caps look to have rebounded in February.

"We saw a bit of a bounce in the small-caps funds, and quite a bounce compared to Australian equities and listed property and a few other asset classes, which continued to be hit pretty hard,'' Mr Serhan says.

"The thing about the small caps is that they're hard to talk about in a general sense - it's harder to identify broader themes in that space.

"That's the nature of the underlying companies - the small-cap area is far more spread in terms of what the companies do than the large caps.

"Quite simply, it's a stock-picking space. In this sort of environment those managers who have had an eye for quality in terms of earnings and balance sheets should come through this process a bit better.

"They definitely have a lot of room to play in, in terms of spotting value. The managers that bounce back strongest will be those that have the best stock-picking ability.''