Microcaps: the forgotten performers

These days, microcaps do not attract much interest with equity investors, but as John Wilkinson reports, there is good cause for that to change.

Although the microcap sector acounts for 80 per cent of the listed companies in Australia, it is an area which does not attract much interest among equity invest-ors and fund managers.

However, the recently formed Acorn Capital has undertaken the most extensive research in the area, with Rothschild occasionally investing in the sector.

Acorn managing director Barry Fairley says the company tends to be the only player when it comes to bidding for mandates. He also admits that a few more fund managers competing in the sector would help lift the profile of microcaps with investors.

The definition of microcaps varies, but consensus says they are the listed companies that rank from 250 to 1300 in market capitalisation on the Australian Stock Exchange (ASX).

The sector has a total market capitalisation of $33 billion, with the average market capitalisation being $32 million. The smallest stock in the sector has a market capitalisation of less than $1 million.

Acorn's investment strategy has been to look at the entire microcap sector and then filter that down to 850 stocks. Fairley says the company now has a research list that consists of 250 companies with a portfolio constructed of between 50 to 75 microcap stocks.

This gives a diversified portfolio that tends not to include the more traditional sectors, such as banking and media.

Fairley says when an investor looks at the All Ords, they should bear in mind that banks and finance make up 19.7 per cent of the sector and media 18.3 per cent. By comparison, banks comprise only 1.1 per cent of the microcaps sector, while media is 2.5 per cent.

"Microcaps represent a lot of engineering and service companies, with a high percentage of developing companies."

Developing companies give up to half of the best returns from the sector, according to research by Acorn. There is a high volume of turnover on these stocks when they are discovered.

Fairley says this leads to a volatile sector where returns swing dramatically depending on the proportion of these stocks in a portfolio.

However, the discovered stocks sometimes go on to become market darlings in the All Ords. Microcap stocks that have made the transition include Challenger International (almost a 100 per cent return in the last 10 years), Harvey Norman (50 per cent return) and Biota (45 per cent return).

Finding the potential growth stocks might be hard for the average investor, as the microcap sector is under-researched. The lack of research by the major brokers into this sector means investors do not get stocks recommended, and fund managers leave microcaps alone because of their market capitalisation.

The microcap sector is not for the mums and dads. Acorn believes microcaps should be about five per cent of a portfolio exceeding $1 million.

Investing in the sector would also tend to favour the managed fund approach. An investor would have to invest in about 60 stocks to cover five per cent of the stock in microcaps.

The problem for investors to date is that there have been very few opportunities to invest in the sector from the retail perspective. Acorn has been seeking mandates in the wholesale sector and has been successful winning a few in recent months.

Acorn is to be a manager of the first retail microcap fund to be launched this month by Australian Unity, which owns 50 per cent of the company. The minimum investment in this emerging companies trust will be $100,000.