Max Pacella
Investment Analyst
1 Apr, 2021

When considering the domestic equity exposure in a portfolio, one important consideration is what market capitalisation you are investing into.

Much like different nations of varying economic size, different sizes of companies within the same economy offer different investment characteristics.

Often overlooked by a broader portfolio, Australian small companies (“small caps”) offer their own unique set of risk characteristics, expected return profiles and market behaviours. As a rule of thumb, a company is considered a small cap if it has a market capitalisation of between $50 million and $500 million AUD.

Traditionally, small cap investments are expected to have higher volatility – and risks – in return for a higher return profile.

However, their risk-adjusted return profile is still very attractive.

Source: Bloomberg

As of yesterday’s market open, the ASX Small Ordinaries (white line) outperformed the ASX 100 (blue line) by over 11% during 2020.

There are a raft of economic factors influencing this performance, but from an overall perspective the old saying still holds: “size isn’t everything”.

Today let’s touch on some factors which lend domestic small caps their return profile and what to watch out for when assessing equity exposures in future.

Sector Exposure Comparison

By way of background: Australian small caps have a different market sector composition to the ASX 200, with a far greater weighting towards Real Estate, Consumer Discretionary and Tech.

By their nature, these companies can start operations with relatively lower levels of initial capital expenditure than a miner (large up-front construction costs) or a financial institution (large capital pool requirements), meaning less barriers to entry and gaining market share.

Source: Bloomberg, Mason Stevens (31/03/2021)

Greater Chance of Pricing Inefficiency

The terms ‘market inefficiency’ or ‘pricing inefficiency’ refer to the concept that an asset/stock’s price does not reflect its true value – in other words, the market has not priced in all of the projected earnings and company information available to it.

In large cap stocks, this is increasingly difficult to find. Major institutional banks around the globe have analysts scouring each market sector. Rapid advances in technology have made access to information faster and easier to all levels of investor and algorithms are programmed to track financial announcements made by some of the largest companies in all major indexes.

But one of the advantages of investing into small companies is that they are still considered an ‘inefficient market’, particularly in Australia. There are simply not enough hours in the day or analysts at a desk to analyse every company below A$500 million valuation, particularly since these companies may be new or operating in a niche area so do not have wide publication of information or resources to run high-profile investor presentations.

Source: Jade Financial Group

Though the data above is as of March 2020, the performance profile of our domestic small cap market relative to other equities is evident over the long term. The reason that many domestic fund managers cite is their ability to exploit pricing anomalies by seeking out companies which are not well covered by analysts and therefore have not yet attracted market attention.

Easier to Increase Market Share

One contrast which is drawn between large and small companies is the implicit ability of a smaller company to grow its market share significantly with relative ease compared to its larger competitor.

How are the four major banks going to double or triple in size when they hold a collective market share of 80%?

It’s much easier to grow a small company than it is to double the entire size of the market.

Due to their smaller size, small companies are nimble and can make the sometimes difficult or opportunistic choices to grow market share quickly without moving a bloaty operation or needing several layers of bureaucratic approval – this is not the case for all large caps of course, but in general terms a smaller company will entail a smaller executive team.

For those investing through a small company manager, the rule of being nimble still applies – there are certain ‘caps’ at which the levels of Funds Under Management (FUM) mean positions in small companies become too large to rotate quickly (generally around $400 million). This can erode performance since once an inefficiency is corrected by the market, the opportunity for value growth may be gone and the manager needs to the find the next opportunity.

The game of small caps, to reference an old idiom, is one between the quick and the dead.

Owner Operators

This factor is a little harder to quantify from an economic standpoint, but there is anecdotal evidence of firms run by founders/owners maintaining a stake in the business producing better financial results.

Why is this? The answer is a blend of psychology and economics:

A measure of company value, one that Warren Buffet espouses particularly often in relation to his investment philosophy, is per share value and maintaining value for shareholders. Using the examples of an appointed CEO who operates off a salary and stock options, rather than ‘skin in the game’, Buffet and others warn that transactions may be made which actually erode per share value for the end investor for the sake of meeting goals or expanding corporate profile.

The examples of these kind of transactions justify their own note (one which I hope to write soon), but for now we will take this assumption at face value and ask, “How do we prevent this?”

Owner operators can be one answer to this.

Owners and founders usually have grown the business and have an emotional vested interest to see it succeed. Whilst an economic value cannot easily be placed on passion for business, some of the most recognisable names in the business world – Bezos, Musk, Gates, Zuckerberg et al – are founders of their own businesses, and have used their passion and commitment to create disruptive businesses and act as owners rather than just an appointed officer.

This extra factor is often found in smaller companies (globally and domestically) – the nature of large corporate deals and investment banking lends itself to incumbent owners selling down their positions to assemble a high-profile executive team and board upon taking the company public.

For small caps, the chairman/CEO is often wearing many hats in the business, was one of the founding members, or both and therefore is not only extremely knowledgeable about all levels of the operation but understands how to most effectively spend and grow capital for its owners.

Looking Out for the Little Guy

Small companies offer some unique characteristics and opportunities for growth, though are not without their risks. Much as this note has espoused that you need to be quick and nimble, this does not just apply to buying – the inherent volatility in these companies means that investors need to carefully manage their risk and time their exit accordingly.

For investors seeking a higher growth profile, whilst diversifying their exposure away from the large companies within the Australian market, there are certainly opportunities within small companies as part of a well-managed, risk-adjusted portfolio.

Small caps can seem to be an art more than a science – as does most investing at times – since some of the factors which make them most compelling are also difficult quantify. This needn’t scare investors away from the sector, only to think differently and look where others have not.

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.