Lonsec Small Caps review points to lower returns

Leading ratings house Lonsec has used its latest small cap Australian equity sector review to warn that the small cap market is arguably over-valued and there is a general expectation of low double digit returns in 2007.

The review has resulted in three funds receiving ‘highly recommended’ ratings, 10 receiving ‘recommended’ ratings, nine receiving ‘investment grade’ ratings, two receiving ‘hold’ ratings and two receiving ‘fund watch’ ratings.

The funds to earn a ‘highly recommended’ rating were Eley Griffiths Group Small Companies Fund, Ausbil Australian Emerging Leaders Fund and Pengana Emerging Companies Fund.

A number of funds were upgraded as a result of the review, including Colonial First State Small Companies Fund — Core from ‘investment grade’ to ‘recommended’, Hyperion Australian Small Growth Companies Fund from ‘investment grade’ to ‘recommended’, Macquarie Australian Small Companies Fund from ‘hold’ to ‘investment grade’ and Portfolio Partners Emerging Shares Fund from ‘hold’ to ‘investment grade’.

The review also pointed to the recent level of employment churn in the Australian equities small cap sector and said that this had led to an increasing number of institutional managers adopting more innovative incentive and remuneration structures to help retain key staff.

Discussing the broad outlook for the small caps Australian equity sector, the Lonsec review concluded that in contrast to their large cap peers, the small cap managers had received “no free kicks” from takeover activity.

It said many small cap managers had not greatly benefited from the recent surge in private equity or leveraged buy-out activity, despite takeover activity having been rife in the small cap end of the market.

The review said, however, that the general characteristics and types of companies that were targeted by private equity funds were not attractive to most small cap managers.

Looking at the question of whether the small cap marketwas over-valued, the review said while the market had delivered exceptional returns over the last three years of around 26.9 per cent, the general expectation was for low double digit returns for 2007.

“Although the returns generated by the small cap market have been broadly commensurate with profit growth in the sector, it is worth noting that the small cap market is currently trading above its historical price/earnings average of 12 times,” the review said.

“In addition, the small cap market has historically traded at a moderate discount to the large cap market, predominantly due to the higher levels of implied risk.”