The ‘small caps’ theme is a crowded trade on the ASX so it’s time to look beyond the Top 20

Everyone is looking for small caps but you don’t have to hunt too hard to find bargains on the Australian sharemarket.

Opportunities are emerging outside the top-20 ASX stocks.

Sharemarkets have had a strong 12 months. The MSCI All Countries World Index ex Australia rallied 28.72 per cent to the end of March.

While that's an amazing result over the year, Australia lagged substantially – up only 14.45 per cent over the same period.

Much has been written lately on the valuations of small caps and the discount they are currently sitting at compared with the indices. There's been a lot of commentary around why investors should be looking at these as part of their Australian equity portfolio allocations.

Small caps have traditionally underperformed during an economic slowdown or when the stockmarket has been down. Downside participation has usually been greater then – and likewise upside participation during an upswing.

There are those who have stock picked and been fortunate to own some well-known winners, such as WiseTech Global or ProMedicus.

But small and micro caps have also been a graveyard for individual investors and, as a sector, is notorious for losses.

Why is that so? Timing is extremely difficult to get right – and it’s easy to buy and difficult to sell, especially when a market is correcting.

For that reason, we have preferred “broadcaps” and mandates beyond the top 20 on the ASX where the fund manager can move across the investment universe.

While we run portfolios on a tactical asset allocation basis against strategic benchmarks based on a client’s risk profile, one aspect I always look at when selecting a fund manager is their downside participation.

We look at how they are avoiding the losers, against their peers, and analysing returns across the return periods and not just one year.

Analysing short-term performance data can be fraught with danger as everything is at a point in time. This can make something look attractive in a moment in time – or not so. Long-term performance is what is important.

A new report from Yarra Capital Management illustrates 10 and 20-year returns and volatility or risk.

While “smalls” on their own have dramatically underperformed over three, five, 10 and 20 years, it is the outperformance of the ASX 300, ex the top 20 stocks, which is compelling. Yarra Capital Management executive chair and head of Australian equities Dion Hershan explained these numbers during a recent presentation where he spoke about the “ex-20” performance, and the opportunity there.

He said that once you venture outside the largest 20 companies, you are looking at about 35 per cent of the ASX 200 – which is still a meaningful part of the market.

“It is also far less efficient, providing excellent opportunities for astute active investors,” he said.

“Pleasingly, as you venture into midcaps you often find companies with proven business models that touch the full spectrum of the economy.

“They exhibit real growth potential and investors are spoiled for choice in terms of the number of companies to invest in. And, critically, a lot of midcaps are not hostage to Australia's broader growth prospects.

“Very often we find companies with small market share, but which are growing quickly, or companies that are Australian businesses expanding offshore into global markets where addressable markets are significantly larger.”

Against this backdrop, I find it interesting that there is such a broad push on small companies.

While I prefer the broader mandate which gives investors the flexibility to invest across the market capitalisation spectrum, I would say it is important to beware of a crowded trade; buying small caps is a popular trade now.

I have also supported Smallco investment management. Their record is consistent and a positive experience for our clients. With one-year performance of 29 per cent and outperformance of 14.6 per cent and since inception (2008), performance of 16.4 per cent and outperformance of 8.9 per cent per annum.

Managers like Yarra Capital and Smallco put a strong emphasis on valuations and earnings growth to produce the returns they do.

My advice to all investors is, regardless of where you invest across the market capitalisation sphere, stick to quality and strong earnings growth. Do not follow the crowd but always be aware of downside participation, and you will sleep at night.

Will Hamilton is the managing partner of Hamilton Wealth Partners. [e-mail]