Microcaps: of the unloved

Microcaps do not attract much interest with equity investors, although the sector accounts for 80 per cent of the listed companies in Australia.

The lack of interest extends to fund managers in the sector. The recently formed Acorn Capital has undertaken the most extensive research in the area and Rothschild occasionally invests 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 microcaps' profile 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 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 less then $1 million.

Fairley says the top end of microcaps becomes a blur as some of the stocks fall into the ASX Small Ords sector … and that is where other fund managers dip their toes in the sector.

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

This gives a diversified portfolio which 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.

In those sectors a few very large stocks dominate, such as the big four banks in banking and News Corp in media.

By comparison, banks comprise only 1.1 per cent of the microcaps sector, while media is 2.5 per cent.

"Microcaps represent a segment of the economy not represented by the All Ords," Fairley says.

"The sector represents 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. The developing companies can have a maximum turnover in the stock of $33 billion in a year. This would compare to a $10 billion turnover in the stock of a mature listed company.

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.

"There are, on average, six analysts per company at the top end of the stock market," says Fairley. "With microcaps, the average is the equivalent of one analyst per 30 companies ? and yet 80 per cent of the best returns come from this sector."

Acorn has five analysts looking at 280 companies, but Fairley admits the data received in the sector is often poor.

"In order to get clean data for the sector, we had to get copies of companies' annual reports and scan in the financial data," he says. This was followed up by more in-depth research on individual companies.

"The objective is to identify those companies with good products, in good markets and with good management focused on the interests of shareholders," Fairley says.

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.

"Since the mid nineties, stocks have been priced by size as well as investment arithmetic, thereby disadvantaging microcaps," Fairley says.

The microcap sector is not for the mums and dads. Acorn believes microcaps should be about 5 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 5 per cent of the stock in microcaps and a third of the portfolio would have to be in growth stocks to outperform any benchmark, says Fairley.

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 and Fairley says this opens opportunities for planners to invest client's funds in the sector on behalf of clients.

Investment returns to October 31, 2000