Smart money moves on ‘small caps’

When it comes to making money in small caps, it’s wise to pick carefully, and make them small. But not too small.

Suddenly there is a lot of excitement around the Australian small-caps sector. The theory goes — the small-cap sector is ­firing on all cylinders and with blue chips looking subdued this year — it’s the small caps that will fly. The theory is, of course, silly.

That’s because the idea of grouping thousands of small caps together is not feasible — they have so little in common other than the fact they are small.

Sure, healthcare is a sector or media is sector … small caps is not a sector.

It’s like saying every business in the country will do worse next year because GDP forecasts have been downgraded — well some businesses are great, some are ­mediocre and some are useless: a “top down” theory is going to have little effect on the individual ­performance within the wider world of commerce, the same goes for small caps.

In other words, a particular small cap is not going to do better because of any “macro theme” — especially a theme as dubious as the one which suggests investors will buy small caps because big caps are not attractive.

For example, if you look at the graph today you can see that small-cap stocks are doing quite well — in the year to date they are trading better than the entire market — if you exclude resources stocks they are doing better still. But, there’s the nub … there are thousands of small-cap stocks, which ones are driving the out­performance?

Index investing in small caps in Australia has been a mug’s game for many years and we have had endless false starts on this theory right back to 2007. Superstar fund manager Chris Cuffe noted in these pages just last weekend: “The active managers of small-cap industrials generally do better than an index because they can find small under-researched stocks.” As my colleague Richard Hemming, who writes the Under The Radar column (see below) would have it, investing in small-cap stocks is all about “picking” a portfolio from the vast spread of choices put before us on the ASX.

Crucially, the most potent point about stockpicking in the small-cap market is that the number of stocks that remain “under researched” grows each year as broking houses simply cannot ­afford to pay researchers to spend time looking beyond the usual suspects within the ranks of well-known blue chips.

What’s more, there are dozens of small-cap stocks that are first class; moreover, they pay dividends that can be just as reliable as blue chips.

It’s this information gap that gives either the individual investor or the professional fund manager the chance to genuinely beat the market. Witness the long-term performance of fund managers such as David Paradice or the remarkable — though less well known — Michael Glennon in recent years. There are also impressive operators inside the mainstream investment houses — Jack Collopy at Perpetual’s small-cap fund for example has managed to return 23 per cent a year for the past two years while the wider market has done very little at all.

There are of course risks that exist in the small-cap market that are unique to companies of this size — these can be split into internal and external factors:

● Internal: the key risk here is management risk — where one person such as Ray Malone at the dazzlingly effective AMA motor repairs group would appear to the essential asset in the group — but then again you might say that about Gerry Harvey at Harvey Norman, Don Meij at Domino’s Pizza and other companies that have now elevated beyond small cap status

● External: apart from the ­traditional issue of liquidity, small caps are prey to shorting: this is perhaps the single most dangerous aspect of contemporary small cap markets where CFD players and other operators have become dominant. It is much easier to pull off a shorting attack against a small cap than, say, Commonwealth Bank.

There is also a unique danger in the local market that small caps can be laughably small — often with market capitalisations that run below the cost of a harbourside home in Sydney! In offshore markets the capitalisation required to list on national sharemarkets tends to be considerably higher: This aspect amplifies the risk of unprofessional management not to mention poor liquidity (the problem that nobody is in the market might want to buy shares when you want to sell).

That’s why the best professional small-cap managers offer a keen lesson to private investors who want to make money in small caps — first, pick carefully, and make them small — but not too small. The ideal market capitalisation range is between $20m and $200m. After that the last thing to be said is that when small caps come right they are just wonderful — just ask anyone who has had money in this year’s small-cap darling, the infant formula maker Bellamys, which started the year at $1.65 and was trading yesterday at more than $8. Or to take an extreme example, the gold miner St Barbara, which was trading at 11c this time last year and hit $1.29 yesterday — that’s what they call “10 bagger”, you don’t need many of those to make your portfolio look a lot healthier at the end of the year.

James Kirby is the managing editor of eurekareport.com.au.