By Stewart Oldfield
The top end of town is facing growing challenges to investing in small listed companies which could throw up opportunities for nimble investors.
As the giant super funds grow their funds under management by tens of billions of dollars, their ability to generate meaningful outperformance by investing in Australian small-cap stocks becomes more challenging.
The need to continually find new investment ideas and be able to implement those ideas encourages the biggest asset owners to focus on much bigger companies.
One of the big asset owners Rest Super unwound an internal Australian small-cap investment fund in late 2021.
Last year a small-cap specialist Karara Capital announced that after the decision of senior Karara team members to retire and/or pursue other opportunities, it would cease managing funds for external clients after more than a decade.
“The Karara management and investment team are proud of this long-term track record that has provided investors with net investment returns significantly in excess of the benchmark,” it told clients.
A number of small-cap investment firms are rolling out mid-cap offerings as a means of staying relevant to their biggest clients.
James Gunn, head of equities at Frontier Advisors, expects large asset owners (with the possible exception of some mega funds) to continue to invest in small caps for some time yet despite greater liquidity challenges presented by their growing size.
But the way they get their exposure to the sector might change.
“You clearly can’t just give 3 or 4 billion dollars to one small-cap manager – they would be substantial in everything,” he says.
He says big funds are increasingly employing a mix of strategies in the small-cap sector. In addition to their incumbent small-cap exposures, they may have internally managed small-cap portfolios as well as more scalable hybrid allocations to both mid caps and small caps and even lower-cost and more diversified systematic or alt beta/factor allocations to the sector.
“You can’t say there is a specific level of assets that you should not be investing in small caps as it is strategy-dependent.”
Gunn says his firm maintains a strong conviction in the value of maintaining a dedicated exposure to high-quality small-cap fund managers where possible.
Indeed, with the potential of a lower returning market environment going forward, the value of the potential outperformance from small caps – even if they are a relatively small part of an asset owners’ total allocation to equities – could prove invaluable.
He says a number of well-regarded Australian small-cap managers are open to potential new clients as a result of consolidation in the superannuation sector.
“A couple of years ago there were a lot less open small-cap managers.”
Big asset owners such as the $70 billion REST and the $260 billion AustraliaSuper say they remain committed to investing in small caps.
A spokesman for REST says small-cap investment capabilities and exposures are still a feature of its portfolio and are managed “holistically” by its team.
AustralianSuper senior portfolio manager Luke Smith says the country’s biggest super fund has about $5 billion invested in companies outside the S&P/ASX 100 that it believes have the potential to outperform the S&P/ASX 200 over the longer term.
“To date, our size hasn’t been an impediment to investing in companies that match the return profile we are seeking,” Smith says.
This commitment to small-cap shares comes despite a tough run for small caps on the share market.
Over the past decade, small-cap stocks have generated a total annualised return of about 5 per cent compared with the top 100 industrial stocks returning more than 9 per cent.
Last year, small-cap industrial stocks had their worst year in more than 20 years relative to big-cap industrial stocks as concerns about the impact of rising interest rates and energy costs led to lower profit expectations.
Following the underperformance, specialist small-cap investors say the outlook for the sector this year is bright.
Katie Hudson, head of Australian equities research at Yarra Capital, says Australian small-cap stocks are trading at the biggest discount to big cap-stocks in 20 years after an indiscriminate sell-off last year.
“With the ‘growth’ sell off last year, and particularly in the industrial part of the market, we’re finding a lot of opportunities to invest in,” she says.
She said small caps could enjoy a number of tailwinds this year including a stronger Australian dollar which helps with the cost of imports for small-cap companies.
“Small caps tend to do better in an environment where the Australian economy is doing relatively better. And certainly, our macro view is that Australia should fare relatively better economically than some offshore markets,” Hudson says.
Oscar Oberg, lead manager of a number of portfolios at Wilson Asset Management, notes that the valuation gap between US big-cap and small-cap stocks had stretched to a 25-year-high last year.
“We are very positive about the outlook for small caps. We have seen a noticeable turnaround in the January period,” he adds.
WAM highlights the prospects of specialist sea vessel provider MMA Offshore and Singapore-mobile play Tuas as being particularly attractive.
Broker Evans and Partners says the best way to play the recovery in small caps is through specialist managers.
“The Australian funds on our high conviction list are Eiger, OC Premium and SGH ICE. For global exposure we prefer Fairlight,” the broker adds.
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