Max Pacella
Investment Analyst
19 Aug, 2021

In my role here at Mason Stevens, an interesting part of my week is speaking with investment managers from all different asset classes and disciplines.

It gives a fantastic insight to how different professionals view the market, what investor sentiment is and is moving towards, and (most interestingly) what strategies and asset classes can generate portfolio alpha.

One key area that many of our investors are overweight is small companies, or “small caps”, both domestic and international. In terms of domestic markets, we define the S&P Small Ordinaries as companies within the ASX 300 but below the ASX 100 – giving a market capitalisation of a few hundred million up to $2 billion AUD.

There is one core reason why small companies are enticing as an exposure; small caps are expected to yield a higher return, albeit with more volatility, so it’s a compelling “growth” allocation within a portfolio.

Source: Bloomberg

Since the start of financial market’s recovery from the pandemic lows, the ASX Small Ordinaries has outperformed the ASX 200 by over 25% to date.

Investing in small caps is not as easy as that outperformance may make it seem however, and for both professional managers and individual investors, there are certain qualities and risks which you should be aware of when looking to incorporate this exposure into your portfolio.

Benefits of Investing in Small Companies

There are a few key benefits to investing into small caps which tend to drive most investor interest towards that part of the equity market.

1) High growth potential

These are companies often in the infancy of their business life-cycle, still establishing market presence, key customers, business infrastructure etc. This provides an opportunity for the successful stock-picker to enter a company at a relatively low size and valuation to its potential mature profile.

2) Disruptive models

The next “disruptors” of existing business models may be found in the small cap sector. Given that the very nature of disruption is to subvert or break off from existing business models or sectors, it is less likely (though not impossible) that a large company will pivot towards being a disruptor again, “it takes a long time to turn a large ship” applies here.

3) Inefficient markets and information asymmetry

The efficient market hypothesis (EMH) states that the price of the market reflects all information available to market participants at any given time, meaning that stocks are perfectly priced. In the long run EMH tends to work, less so in the short-term.

Small companies tend to be less efficient markets, where the diligent investor can find valuable information where others simply have not looked – this is assisted by the fact that most “sell-side research” by major brokers and banks do not often extend down past the ASX 200.

With these benefits there are risks which need to be weighed up against what potential return you may be seeking.

Small companies tend to be more volatile and subject to wider price swings, which is a primary concern for many investors whose risk profile may not suit capital fluctuations in the short and medium term.

There is also less liquidity in many listed small companies, with larger gyrations in price and occasional difficulties in completing relatively larger buy or sell transactions for larger scale investments where several million dollars could be a large portion of the daily stock turnover of that security.

The “Little Details”

Small caps are notoriously difficult to place a keen valuation on by standard metrics.

The primary reason is that many smaller companies are not at the stage they are producing reliable revenue yet, or not yet at the stage where that revenue is translating into profit (earnings).

This is why your eyes might boggle as a rising small cap star boasts a P/E ratio of close to 100x, there simply isn’t the earnings to support the price.

So, what are others seeing to drive that price, and how can you see when the price is reasonable?

There are several investors who have fundamentally shaped my own view of equities, each of whom have been named “value investors” despite buying companies which they saw as holding tremendous “growth” potential; Warren Buffett, Phillip Fischer and Peter Lynch.

Albeit famous for owning some of the largest companies in the world, each of these investors also started out generating large returns in small companies, and their analysis of “quality” over value/growth may give insight into how you can analyse potential small cap holdings:

1) Earnings Growth is a key metric used to analyse if what a small company is doing, is working. This doesn’t mean profit, it is more analogous to return on equity (ROE), seeing that the investments and decisions the company is making are indeed paying off.

Christopher Mayer wrote an exceptional book called “100 Baggers”, in which he outlined the twin engines of growing earnings and an expanding P/E multiple as a very positive sign for the growth of a small company.

2) Investing in R&D is a crucial component of many small companies. This plays into two logical factors, being building the business and explaining lack of profitability.

Investing into R&D helps a business build a competitive advantage, also known as a “moat”, across multiple facets including intellectual property, product and technology, key logistic infrastructure and more.

Furthermore, if earnings are depressed, many may overlook the company as a losing play. If you can look behind that report and see that earnings were low because gross revenue was re-invested into putting the business in a stronger position, this is a positive sign of a growth mindset. Which leads nicely to…

3) Knowing Management is one of the most important factors that Buffet, Lunch, Fischer and most small cap managers you speak to will espouse. When you are investing into a company with relatively little financial history, you are placing a tremendous amount of trust in the capability of the men and women at the helm.

This can be achieved without having the connections to speak directly to the CEO, from seeing how the company spends the money it makes, its approach to debt, the history and pedigree of the management and board – even reading the investor report put out with their financial results can operate as a good “pub test” to assess if their vision of the company aligns with what decisions have been made.

All The Small Things

Small cap equities can very much be the Wild West of capital markets: you are on the frontier, taking risks in the hopes of comparable pay-offs, with less information but also less competition.

There are demonstrable track records from managed funds to individual investors, which show that an astute eye and a nose for quality companies can yield alpha in excess of the index.

What is most important to consider is the role of this exposure within a broader portfolio: how will this impact the overall volatility of your portfolio, does this offer a commensurate return profile, does the manager or stocks you have identified share excess correlation with other holdings?

If you can convincingly answer the above, then looking to add companies which are still in their early stages of growth can be a source of high return to the apt investor who can identify opportunities which may be off the beaten path, and off the radar of many others.

The views expressed in this article are the views of the stated author as at the date published and are subject to change based on markets and other conditions. Past performance is not a reliable indicator of future performance. Mason Stevens is only providing general advice in providing this information. You should consider this information, along with all your other investments and strategies when assessing the appropriateness of the information to your individual circumstances. Mason Stevens and its associates and their respective directors and other staff each declare that they may hold interests in securities and/or earn fees or other benefits from transactions arising as a result of information contained in this article.