By Ally Selby
Although the last two months have been marked by increased volatility and disruption, small caps have largely outperformed.
During March, small caps performed broadly in line with their larger counterparts, with the ASX Small Ordinaries Index dropping 20%, compared to the S&P/ASX 50’s fall of 17.3%.
Since the beginning of April, both small and large caps bounced back – with small caps disproportionately reaping the rewards of the COVID-19 recovery. The index has lifted 18.3% since the beginning of April, compared to the top 50 lifting only 3.2%.
Although returns have been varied, Macquarie Australian Small Companies Fund portfolio manager Derek Bilney told Financial Standard small caps have more potential for growth over the coming months.
“The last two months has seen amazing changes sweep across global economies, industries and society in general – ideas that would have otherwise taken years and years to gain traction are being rapidly embraced and old ideologies cast aside,” he said.
“Small-caps and micro-caps are better placed to benefit from this accelerated revolution.”
Similarly, Australian Ethical portfolio manager Andy Gracey said many small caps are now trading at a premium to their large cap counterparts.
“The market is now reasonable comfortable with small caps, which is a bit counterintuitive – usually during economic recessions large cap stocks hold up well,” he said.
“But that’s the thing about the COVID-19 sell-off; it hasn’t been a classic economic sell-off, instead, it’s been quite random in terms of which businesses have suffered and which have done well.”
Although large caps have their place in portfolios – they traditionally provide a source of income in dividends (although this is uncertain in the current environment), small caps are more likely to deliver growth, Gracey said.
“If you’re looking for growth, small companies are a great way to play that,” he said.
“The large companies in Australia are dominated by banks; you may get a little bit of capital appreciation if you bought some now, because they are still one of the few sectors that hasn’t really rallied, but small companies have got much higher growth abilities and chances of capital gains.”
To benefit in the months ahead, Bilney recommends investing in quality companies rather than taking large sector exposures.
“We believe winners are identified through the three pillars of our proprietary model – valuation, quality, sentiment,” Bilney said.
These stocks have a higher probability of outperforming in the Australian market, he said.
“We believe that a thematically balanced portfolio, underpinned by such companies, spread across different market segments will minimise the impact of negative surprises and generate the most consistent outcome,” Bilney said.
The fund is overweight in information technology stocks, as well as resources and energy – which score well from a valuation perspective, he said.
The fund is also overweight to the more defensive communications services sector, however, Bilney remains cautious on REITs – with uncertainty surrounding the ability of landlords to collect rental and lease payments from tenants ongoing.
Wilson Asset Management lead portfolio manager Oscar Oberg said strong leadership was also an important factor when identifying small caps with potential for growth.
“Outside of valuation we would consider the quality of management and the board of a small cap company as incredibly important to determine the winners and losers,” he said.
“Small cap companies are often in an early stage of their life in terms of growth so it is important that there are experienced people on the board to guide management and ensure that shareholder funds are not wasted and are used to generate returns in excess of a company’s cost of capital.”
Gracey believes business flexibility to be key and argues globally-focused companies with defensive qualities and reoccurring revenue or subscription-based models will be better placed to weather the COVID-19 crisis.
Businesses with some kind of intellectual property – whether it be in software of healthcare – would also likely outperform, he said.
Although the small cap rebound has been led by the technology and resource sector, in particular, by companies with exposure to gold – Oberg believes the tech sector may disappoint in the months ahead.
“We think a number of these companies have run too hard and are now trading on valuations that were higher than what they were prior to COVID-19,” he said.
“Given its incredible run over the last month, we believe the technology sector is due for a pullback and believe that investors should be discerning around valuations and the quality of companies within this space.”
In contrast, Gracey believes there is still upside in the technology space, particularly for SaaS companies.
He likes Macquarie Telecom (ASX: MAQ), Big Tin Can (ASX: BTH) and Nitro Software (ASX: NTO) in this sector.
However, he has been disappointed in software education company 3P Learning (ASX: 3PL), which he said had been resilient but hadn’t as yet shown itself to be an outperformer.
Gracey also believes healthcare would continue to benefit over the coming months, and likes Fisher & Paykel Healthcare (ASX: FPH), Cyclopharm (ASX: CYC) and Immutep (ASX: IMM).
WAM has benefited from the small cap rally by investing in quality companies in agriculture and those likely to benefit from easing restrictions, Oberg said.
“We have played the agriculture sector through Graincorp (ASX: GNC) and Elders (ASX: ELD) with both companies recently reporting a strong set of half-year results,” he said.
“We continue to see upside for both companies given the likelihood of an above average wheat crop and high livestock prices.”
The automotive sector is likely to do well over the coming months, he said, with Australia emerging from lockdowns earlier than its peers.
He points to companies like Bapcor (ASX: BAP), AMA Group (ASX: AMA) and Viva Energy (ASX: VEA) as key beneficiaries as people start driving to work or driving interstate to go on holidays.
For the same reason, Oberg is positive on the travel sector and likes stocks such as Webjet (ASX: WEB), Ingenia (ASX: INA) and Sealink (ASX: SLK).
Meanwhile, Bilney’s small cap picks for the coming months are Spark New Zealand (ASX: SPK), Beach Petroleum (ASX: BPT) and Saracen Mineral Holdings (ASX: SAR).