Stockpicking gets results for small caps

Small cap managers are improving their investment processes and honing their stockpicking skills to produce consistently strong performance,van Eyk Research’s 2003 Small Cap Australian Equities Sector Review has found.

Released today, the review is the largest yet undertaken by van Eyk in this sector, covering 15 managers and 17 strategies, including eight managers previously unreviewed.

The review found that all managers with three year track records (12 of the 15 managers reviewed) significantly outperformed the Small Cap Index for the three years to June 2003, generating average total annualised returns of around 13.4 per cent, compared to the Index return of negative 0.4 per cent.

For the whole group, the one year average return was 8 per cent, far above the benchmark return of negative 3.7 per cent.

According to van Eyk analyst Suzanne Tavill, small cap managers display “distinct characteristics from their larger cap cousins - such as the ability to consistently add value through active, bottom-up stock selection, regardless of investment style”.

“We don’t think style plays as an important role in small caps as it does with large cap managers, instead stock selection drives alpha.”

Tavill says there is a growing trend of managers in the small cap space looking into the micro universe for more options, and significant micro cap exposure has enhanced performance.

Increased competition for funds and tighter information flow has also prompted small cap mangers to become more rigorous and structured in their analysis.

“In comparison to large cap managers, small cap managers have a potential universe of over 1,000 companies. This highlights the importance of appropriately defining the universe, applying screening/filtering mechanisms, and having strong overall idea generation,” she says.

“We believe this is a crucial aspect of the stock selection process. The days when a manager could survive on a good gossip over lunch are long gone.”

Tavill also attributes the outperformance of small cap managers against the Small Cap Index to its heavy value bias and proliferation of low quality companies.

The review highlighted the impact of fund size, with most managers believing that once a fund reached approximately 1 per cent of the Small Ords capitalisation (or funds under management of $570 million), size could begin to cause performance degradation. This has resulted in a number of managers closing their funds to new funds flow, also rendering them ineligible for a AA rating.

Van Eyk has recommended nine funds, with two funds receiving a top AA rating and seven funds receiving an A rating, and recommends investors place around 10 per cent of Australian equity exposure into a small cap strategy, through a maximum of two managers.