Small cap investment: the might of the minis

The class of 2005 in the Australian small and micro cap funds sector have been getting a reasonably good wrap of late — despite warnings about the end of a two-year bull run.

Recent surveys by Morningstar, Mercer and now a sector report by Standard & Poor’s (S&P) show that this dynamic area for funds has a couple of themes that continue to resonate for the future.

As MorningStar points out, small caps may not be a true boom/bust proposition, but there certainly can be wild fluctuations in fortunes and the occasional twin peaks pattern. The latest research by S&P gives the thumbs up to the star performers, including: Challenger’s James Ring and his team, Soul’s Frank Villante and boutiques such as Eley Griffiths (EGG).

The smell of success

Brian Eley, a co-owner of EGG, says the secret to their success with $350 million in funds under management (FUM) is focus and performance, and that means head down, tail up and no Golf Days. He did sneak off to watch the Cup, but then he was back at it 10 minutes later.

Their big stakes include non-residential construction (Coate), healthcare (Ramsay, Primary) small oils (Arc Energy and Australian Worldwide Exploration), IT and portfolio services (Cabcharge, Iress, iiNet).

Predictably, October has been a cashed-up month for EGG, which got down to holding 13 per cent in cash but has since dropped back to 10 per cent. Eley says their maximum is 20 per cent in extreme cases.

“We’ve had an exceptional two and half years, but a lot was off a low base to begin with from March 2003.

“A lot of the first year bounce was catch up — a strong economy and good profits, high employment and booming resources have helped small caps.”

So where to from here? Eley says: “It’s a little harder to gauge. I’d be surprised at another 20 per cent plus year, but there’s sections of the economy doing well.

“Energy, resources, non-residential construction and anything infrastructure — there’s a big replacement cycle going on. Business investment is strong so IT is doing well. With small caps you can get quite focused exposure.”

What’s not doing well? “Anything consumer … we’re very cautious about retail now and Christmas won’t be strong. There’s also inflation coming through.”

Eley adds: “I’m surprised that we haven’t seen more inflation and that means it’s bottled upstream and that it’s likely to be with wholesalers and retailers who are happy to absorb for now.

“With a small cap, we’re bottom up and we take a macro theme into account on individual forecasts, and you stay away from where profits are under pressure and buy where it’s positive. We’re not super confident, but the October correction may be just that … we’re having a bet each way.”

High conviction strategies

According to Ramon Eyck, associate director of S&P and report author, small cap management can owe a lot to conviction, and this really puts the onus squarely on the quality of the investment team, their philosophy and skill.

He explains: “As a researcher, you like to see managers with experience, who have been in it for a long time and are able to implement their processes. Small caps do allow for that.

“If you look at the top 200, the larger companies such as banks and miners have such a sectoral influence that is hard to ignore. Yet in the smaller index, stock picking is the name of the game. The environment can be good to operate in.”

Eyck says that those funds containing larger companies got a substantial boost in performance and those top 20 stocks are challenging the benchmark ‘unaware’ manager.

360-degree research

Matthew Ryland, senior portfolio manager at Merrill Lynch Investment Managers (MLIM), is responsible for MLIM’s new Australian Growth Share Fund and their existing Growth Fund. He says the fund team works on the best ideas and ends up with a blended portfolio for maximum effect.

“Most planners will try and call the timing by allocating separately. There’s always a technical allocation issue and, yes, there’s periods when small caps do well, but it’s hard to determine.

“Over the two years to September end this year, the top 50 stocks have gone up 25.15 per cent annualised and ex-100 stocks have also gone up 25.20 per cent, but if you broke it down to the first year, then small caps did better relative to the top 50 and then the top 50 took over in the second year.”

MLIM uses 360-degree research that allows them to target, say, Wesfarmers, and then swing around and look at an array of suppliers and competitors that also represent good investment prospects.

“Nufarm came from our understanding the suppliers of Landmark, a former agricultural business of Wesfarmers. More recently, we liked Wesfarmers for other reasons, namely coal, which led us to other coal companies, in particular Excel Coal.

“Everyone does it to a degree but it depends upon how embedded into the process it is … we use quantitative methods as an input, but it’s only an input.”

He agrees that stock picking is getting tougher, with swarms of new managers all competing in the space. Not everyone will be getting a great report card in the future.

In the past few years, new boutiques such as Pengana have been launched while several large names — Deutsche Bank and UBS — have joined the trail.

Small caps are generally defined as those stocks ranked 101-300 on the Australian sharemarket, based on market capitalisation and liquidity conditions. Investing in small caps appeals because of the ‘lack of efficiency’ in this part of the market and because of the potential for smaller companies to grow at a faster rate, starting as they do from a lower base. But their downside is volatility and cyclical behaviour. They can be tricky to manage at the best of times.

Benefits for investors

From an investor perspective there’s rewards aplenty. According to the S&P report, the median small cap manager has comfortably outperformed its benchmark over three and five years, as well as the large cap benchmark and the median large cap Australian equities manager.

Typically, small cap managers seek to outperform the benchmark by 5 per cent per annum, which has been achieved by the top quartile of managers over three and five year periods. Even the bottom quartile of small cap managers has managed to outperform the small cap benchmark over five years.

S&P also calculates that the dispersion of returns between small cap managers was a massive 40 per cent for the year to September 30, 2005. Finally, the researcher found that even the bottom 25 per cent of managers are well rewarded for the amount of risk taken.

Sector growth

The S&P report also points out that the limits now decreed by fund managers on market size graphically reflect how the small are getting larger. From June 2003 to June 2005, the market cap of the S&P/ASX Small Ordinaries Index increased by 85 per cent, compared to an increase of 43 per cent in the market cap of the S&P/ASX 200 Index.

Eyck says “this growth has had a number of implications, with many managers now emphasising capacity limits in terms of percentage of total market cap rather than FUM”.

He adds: “In addition, much of this growth has occurred at the top end of the small ordinaries index, with the size of the 20 largest companies and their influence on benchmark returns increasing markedly.”

While the total market cap of the S&P/ASX Small Ordinaries has grown by 46 per cent over the past five years, the market cap of the top 20 stocks has increased by 68 per cent. Furthermore, funds can be investing in a spread of micro, small and medium stocks, and, as S&P research shows, performance over time can vary greatly given the range of volatilities.

Constraints on capacity

Capacity constraint has been a key feature of these funds, with highly recommended funds like Investor Mutual’s two funds quickly being closed off to new investors — typically, funds will close at 0.75 per cent to 1 per cent of market cap ($80 billion, as at September, 2005).

“The two things we have to think about is existing investors and what they know and then new investors who are seeking a space. And we want to play to both those needs. If the fund is closed then there’s no room. But a number have substantial money in and we have to cover them and inform their investors,” says Eyck.

For example, the popularity of Investor Mutual is due to its ‘steady eddy’ returns — a reliable level of growth and income that minimises the level of volatility. Investor Mutual also set up their fund with minimal exposure to resources.

However, through a combination of fund outflows and growth in the market cap of the sector, a number of funds have decided to reopen to new money, including AMP, ING, Portfolio Partners and Goldman Sachs JBWere.

Fees and out-performance

Most of the major Australian small companies funds are using performance-based fees, but Eyck says while investors are seeing slightly higher fees there’s still value for money.

Of the managers reviewed by S&P, Ausbil Dexia, Challenger (in the microcap fund), Deutsche, Pengana and Souls all have such fees, ranging from 15-20 per cent per annum. In each case, the fee is paid where the manager outperforms the benchmark and any underperformance must first be made back before the fee can be charged (in the case of the Challenger Microcap Fund, the manager must outperform the benchmark by 1.5 per cent to also cover the annual management fee).

For example, Pengana’s fund delivered 26.7 per cent per annum before the performance fee and after management fees in the 12 months to October’s end, and 25.6 per cent after all fees. Manager Stephen Black says it’s running 9.4 per cent above the benchmark. Pengana’s first performance fee was calculated over six months and a small performance fee was taken at the end of last year.

Eyck says: “When we look at small caps, their objectives are aggressive against the benchmarks. They do set the bar high. Over time, the small cap benchmarks aren’t as good in 2001-03 … but the top quartile of funds did meet that. So the skill factor really does come out.

“We look for a reasonable benchmark. A manager should be using one. For example, Ausbil has a mid-cap mix so their index reflects that. If they didn’t, then purely by asset allocation they would have earned their fees, so it’s the appropriate way to do that.”

In evaluating these fee structures, the S&P report says it’s important to note whether the fee applies for any out-performance of the benchmark (or whether it only applies where there is a positive return), whether the fee accrues in periods where the benchmark is beaten but the portfolio decreases in value, and whether any under-performance in a previous period must be made back before the fee can be applied to a later period.

However, S&P believes that given the level of out-performance in the sector, fees should be charged where the manager exceeds objectives, rather than just the benchmark, which is generally 5-6 per cent above benchmark returns.

Churn and turn factors

Most managers want to keep the level of turnover down for obvious reasons, but in a good market you will still expect to see a high turnover. S&P found that the turnover averaged 53 per cent per annum. This ranged from 17 per cent in the Investors Mutual Small Companies Fund to 110 per cent in the MIR Emerging Opportunities Fund. Most fund managers will take a two to three year outlook given their modelling.

“One attractive thing about small cap is its growth trajectory and you are well rewarded to stick to a business. Within portfolios, you see stocks like that. Going forward, if the market isn’t performing as strongly then we’d expect turnover to drop,” says Eyck.

This level of turnover indicates that managers are, on average, holding companies within the portfolio for two years and, in the case of MIR, for less than one year.

In their latest survey, S&P downgraded some managers on issues relating to reduced confidence in their process, appropriateness of their approach, changes in their teams because new products opened, or manager inexperience.

Eyck says that there will be times where stocks will fall substantially and the manager needs conviction. There will be big stocks that also don’t stack up.

Using their influence

One of the striking things about small cap fund managers is their ability to see beyond management spin and to focus on the management and boards of their targets for the big issues of capital allocation and return. This can be very useful in the development and maturation of those businesses if done constructively.

Unlike institutions involved with large caps, which have smaller stakes and therefore less influence, small cap managers potentially have more push on these companies through their position on the register and therefore more say about the next stages of awareness and growth.

Says Ryland: “Insights into management can be crucial. One of the key attributes we look for is their decisions about allocating capital and their hurdle rates. So if they choose to reinvest then we want to see an attractive rate of return earned on that investment.

“If they can’t, then I want to see the money handed back. I want the management to understand that it’s all about competition for capital. We ask them how they use capital and if they talk about being number one then we’re more careful. Also, we look at things they’ve done in the past and that may include previous companies they were in.

“Sometimes, they can get uncomfortable about the questioning but if they’re confident in running the businesses, it shows.”

Ryland adds: “The simplest trick is to acquire something and bury it in the business, so capital allocation is critical to our assessment of management and boards too.”