Stock picking: small, mid or micro?

The mid-cap stocks enjoyed strong growth in 2004, and has been a favoured sector for investors, but should that be the sector investors focus on in 2005? The simple answer is no, although the sector is still looking attractive.

Lonsec investment analyst Brett Chatfield says during the past 10 years, mid-cap stocks have outperformed the top 20 stocks.

According to Lonsec, the top 21 to 100 stocks on the Australian Stock Exchange returned 39.7 per cent up to December 31. “This is not a new phenomenon, as the mid-cap sector has been outperforming the top 50 significantly for a while,” Chatfield says. “Also, small caps have done well and a number have moved into the mid-cap sector as they are going through the growth phase.”

The key to good returns in the small caps sector is earnings growth, he says. And for investors, the attraction is the lack of research, which means it is still easy to pick potentially good stocks. “Small caps are under-researched, whereas the top 50 is researched to death,” Chatfield says.

Another under-researched sector was micro-caps, until Acorn Capital looked at the sector seven years ago. But interest in the sector has reflected in the value of stocks, despite Acorn being the only fund manager operating in this sector.

Managing director Barry Fairley says: “The valuations were 40 to 50 per cent in favour of micro-caps when compared against the ASX 200. Valuations are now at 10 to 15 per cent, so the gap is closer.”

Another problem in the micro-cap sector is that the number of new floats have swamped the index. But returns for micro-caps are still attractive and companies are reporting improved earnings. According to Acorn, the micro-cap sector has seen one-year returns at 24 per cent, two-year returns at 38 per cent and three-year returns at 26 per cent [as at January 2005].

Current returns keep investors happy, but what happens if there is a downturn in the Australian market? Chatfield argues the only reason why small-cap stocks will get hurt is due to them not having strong balance sheets.

“The top 20 are more defensive stocks and there is always more attraction with defensive shares,” he says.“Mid-cap stocks tend to be related to the Australian economy which, if it is strong, is the main reason why mid-cap earnings are strong. Large-cap stocks have more exposure offshore. When Australia booms, the mid-caps boom.”