Investing in smaller companies has traditionally been seen as a riskier undertaking than investing in large caps, but the concentration risk of the ASX 100 – with its heavy exposure to the financial sector – should also be considered when managing risk, says John Campbell, Managing Director, Avoca Investment Management.
“Financials represent around 40% of the ASX S&P 100 benchmark – providing a worrying level of concentration risk,” Mr Campbell says.
“The oligopolistic big four Australian banks have been a great long term investment – and self-managed super funds in particular have been a major beneficiary. However with ever-increasing capital requirements, increasing government and APRA oversight, likely softening in mortgage lending, and the spectre of encroaching ‘Fin-Tech’, it seems less likely that the returns of the past will be emulated going forward.
“Not surprisingly, all four CEOs of the big banks have voted with their feet and retired in the last two years.
“Conversely, the composition of the S&P/ASX Small Ordinaries is much more balanced and aligned to the Australian economy. For instance, consumer discretionary stocks comprise 22% of the benchmark, Resources (including Energy) 18%, Industrials 10%, Financials 9%, Property 11% and Health care 6%.”*
Mr Campbell says it is important for investors to be aware of index composition.
“Five years ago – with its absurd resources skew of 48% – the S&P/ASX Small Ordinaries benchmark bore little resemblance to the Australian economy. This skew was completely at odds with the Australian economy and was a clear warning signal. It caused massive pain for investors when the inevitable happened in 2010/11 and the China economy started to slow, creating a knock-on effect to commodity prices.
“Since then, concentration risk has diminished in small caps but increased in large caps. Investors need to understand these risks and, in the case of large caps, understand that the glory days of setting and forgetting their portfolios with a huge bank exposure is unlikely to be a smart strategy for the next five years.”
Reduced concentration risk notwithstanding, Mr Campbell says there are a number of other positives of investing in small caps that are worth focusing on.
“A smaller company with a small market share but an attractive business model can grow much faster than a large company with a dominant market share. There is no better place to observe this effect than telecommunications where Telstra – the incumbent with 60-80% share across most of its markets – has significantly underperformed as an investment over the last five years against its more nimble small/mid cap competitors such as TPG.
“By not limiting investment to the top 100, you open up a universe of potential investment ideas far exceeding that on offer in large caps.
“By way of example, there are eight Metals & Mining stocks in the top 100 but there are 26 in the Small Ordinaries and literally hundreds more outside the benchmark. Likewise, there are seven stocks within the Hotels, Restaurants & Leisure sector in the top 100. There are 10 in the Small Ordinaries and again, many more outside the benchmark.
“This breadth allows investors to add more value via judicious stock selection than is generally possible in large caps.
“Finally, of the roughly 25 announced M&A transactions in the past two years in the S&P/ASX 300, only one has occurred in the top 100. M&A has the potential to add significantly to a portfolio with the typical premium of most bids in the 30% to 40% range. It is unlikely that M&A will have much impact in the top 100 but could potentially be material in the Small Ordinaries.
“In short, some of the major hurdles against investing in small caps are no longer there. The excess valuations of the resource bubble are well and truly gone. The index is now well balanced against the economy and has (and continues to have) the cleansing effects of new entrants – often from IPOs – coming in and underperformers dropping out as S&P re-balances its indices.
“Our view is that small caps are a good place to invest going forward given the better opportunity to grow that small companies – with generally smaller market shares – have over large companies, the breadth of opportunity in stock selection, and the greater likelihood of M&A activity benefiting smaller companies than top 100 companies.”
Avoca Investment Management was established in 2011 and manages the Bennelong Avoca Emerging Leaders Fund which primarily selects stocks from the S&P/ASX Small Ordinaries and S&P/ASX Mid-Cap 50 Indices. It typically holds 30 – 50 stocks and is actively managed with investment decisions driven by the team’s assessment of relative value.
*Source: S&P, Factset