Yield-hunters eyeing small caps be careful

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Within equities it is almost universally accepted that smaller cap stocks offer better returns. This idea first took hold in the early 1980s when academics in the US identified what they called the small-cap premium.

As investors sought to take advantage, they traded away the excess return opportunity, and US small caps have underperformed since.

Aussie small caps have underperformed too, by an average of approximately 1 per cent per annum versus large caps since the early 1980s.

In the bull market of the past 10 years, the S&P/ASX 100 index returned 10.3 per cent per annum, while the Small Ordinaries returned 6.5 per cent, and smaller still, the Emerging Companies index returned just 4.2 per cent.

Smaller cap stocks thus underperformed and indeed underwhelmed. And yet, on almost any measure, they entail greater risk.

A fundamental principle of finance is the risk-reward trade-off. which means that if you want a higher return, you need to take on more risk. Thus, generally junk bonds yield more than highly-rated credit, and equities return more than bonds.

Why bother with small caps?

The dispersion of individual stock returns is far greater in the case of small caps. And herein lies the opportunity.

First and foremost, there’s a lot more variety of investment propositions. This includes risk profiles, business models, industry exposures, stage-of-life, corporate governance and management quality.

Most presume smaller cap stocks are lower-quality, and that is admittedly true as a generalisation. After all, there is good reason why small caps in aggregate underwhelm.

On the other hand, there are in fact some very high quality small cap companies that are global leaders in their field.

For example, Audinate’s software has become the global industry standard in digital audio-visual communication networks, and its future is underpinned by the inevitable transition from the old analog solution.

Likewise, Nearmap has the leading technology in its niche market of aerial imagery, which it is using to disrupt and thereby penetrate a large existing market, as well as open up new sub-markets.

More growth?

Smaller cap stocks often offer more growth potential, particularly given a smaller starting base. For example, a lender like Prospa Group with an under-penetrated target market can grow its loan book and earnings much faster than a mature big four bank.

As well, it is possible to gain more direct leverage to an investment theme. For example, Jumbo Interactive is an online-only lotteries re-seller that offers pure exposure to the trend towards purchasing tickets online. Tabcorp, the large cap gaming company that actually operates the lotteries, gains only incrementally from this trend given its legacy distribution that is predominantly based around pubs, newsagents and other retailers.

Furthermore, less investor attention means smaller cap stocks are often less efficiently priced. This means investors are well rewarded for leveraging skill and effort. And uncovering gems comes with additional upside when their value ultimately becomes more widely recognised.

Stocks like Audinate, Nearmap and Jumbo have benefited greatly from increasing broker coverage in recent times. And lastly, the variety in small cap stocks allows investors to gain more genuine diversification in their portfolios.

In contrast, consider that 12 of the widely-held top 20 stocks are all pretty much the same thing: mature, domestic-only oligopolies, with limited growth but decent-enough dividends.

How to win in small caps?

Smaller cap stocks have in aggregate proven to be higher risk and lower reward. This argues against using an index fund. Instead, investors should be selective in what they buy, and just as importantly, what they don’t.

Investors can upend the historical risk-reward proposition by focusing only on high quality companies that have proven and profitable businesses. This will limit risk, and together with growth, also provides the upside.

It means ignoring the siren song of concept stocks and fads. They might capture the imagination with the small chance of a spectacular return, but will on average disappoint.

Julian Beaumont is the investment director of Bennelong Australian Equity Partners

 The article was originally published in the Australian Financial Review: https://www.afr.com/markets/equity-markets/yield-hunters-eyeing-small-caps-need-to-be-careful-20190623-p520ga