Written by Tim Boreham. Clime Asset Management’s Chief Investment Officer, John Abernethy was referenced in the following article, published in Business with The Wall Street Journal, The Australian on 6 August 2014.
REFLECTING investors’ obsession with dividend-paying blue-chip stocks, the Commonwealth Bank’s $130 billion market capitalisation accounts for more than 8 per cent of the Australian sharemarket’s total worth.
The bourse’s five biggest stocks, valued at a collective $525bn, speak for a further 60 per cent.
And the 300 biggest stocks comprise 96 per cent of the market’s circa $1.5 trillion worth.
In contrast, the small caps — the ex-300 stocks with a market cap of $317m or less — are valued at $66bn and there are 1500 of them.
Therein lies a treasure trove of unappreciated and undiscovered gems, offering nimble value seekers the prospect of 100 per cent — or even 1000 per cent — gains.
“By holding a smattering of small caps, returns can outweigh the risks,’’ says Proactive Investors’ managing director Andrew McCrae.
“That said, the volatility can be intense and it’s not for the faint of heart.’’
There’s also the pervading risk of the sparkling trinkets turning out to be fool’s gold, with even the most worthy of plays often starved by lack of access to capital and institutional interest.
Still, with the blue chips (especially the banks) looking fully valued, the small fry should not be ignored in any sensibly diverse portfolio.
Listed investment company Contango Asset Management, which runs small cap funds, believes investors with a five-year investment horizon could “comfortably’’ allocate 5 to 15 per cent of their portfolio to microcaps.
“Some investors may be surprised to discover they have that much invested in one or two large-cap stocks alone,’’ the fund said recently.
Contango Microcap portfolio manager Bill Laister says small-caps typically outperform when risk appetite is strong. “While that might not describe the current environment, we continue to see selected opportunities within the small-cap space,’’ he says.
“This is particularly the case for well-managed small industrial companies with strong earnings-per-share growth prospects and solid balance sheets.’’
On Lincoln Indicators’ reckoning, 1433 stocks have sub-$200m market capitalisation and 644 are in “penny dreadful” territory with sub-$10m worth.
In the last 12 months, these sub-$200m stocks have returned an average 24 per cent in capital gains, compared with a 11 per cent for the broader all-ordinaries index.
But the median result for the sub-$200m cohort — which ignores the outliers with stunning gains — was a far less impressive 3.6 per cent decline.
“High risk for high return is a concept that is generally well accepted by the investment community,’’ says chief executive Elio D’Amato. “But for small-cap investors their exposure to greater risk has not been rewarded.’’
Richard Hemming, author of the Below the Radar newsletter, says no index captures the real health of the small caps, loosely defined as stocks with a market cap between $10m and $250m.
“But overall it’s been a difficult time because so much of the money has been flowing to the ASX200 index,’’ he says.
The small-cap indices also do not capture the previous members that have “graduated” to the big league — the sort of stocks investors should be seeking.
Take the acquisitive gold producer Northern Star Resources, which last year blitzed the ASX200 index with a 115 per cent gain.
Not too long ago the stock was a minnow.
Others are vying for graduation to the big league.
An industrial sector exemplar is Moko Social Media, which ran from 7c in June last year to a high of 33c as it tied up mobile phone content deals with US college alumni and sporting groups.
Shares in aerial mapping innovator NearMap were less than 5c two years ago. They have since soared to as high as 68c as investors grasp the cash-rich company’s potential as a subscription-based alternative to the free Google Maps.
Hemming also cites Tasmanian salmon producer Tassal, which has almost tripled in value over two years — a standout for the listed aquaculture sector which has produced a string of failures in recent years.
Another feature of the small-cap milieu has been keen interest in IPOs based on listed shell companies.
Digital CC, the world’s first bitcoin company listed using the shell of Macro Energy, while Reproductive Health Sciences is rebirthing the moribund AO Energy into an IVF provider. “My sense is that many resources small-cap company promoters didn’t see the lack of funding coming,’’ McCrae says.
“The music stopped suddenly and many are now basically zombie stocks.
“The good news is, this can provide opportunities for investors as the zombies are targeted for repackaging by another mining promoter or as a tech stock and the cycle starts all over again.’’
Hemming says promising small caps tend to be subject to a virtuous cycle once they are “discovered” by brokers and fund managers.
“If they are known they quickly get bought because the market is hungry for alternative stories, but they are really hard to find,’’ he says.
“More analysts will look at them as they reach a size that makes a material difference.’’
In the case of “pre revenue” spec plays, there’s an ever-present danger of the bubble abruptly popping.
Holders of the app-based asthma management company iSonea would appreciate this: their stock hit 88c, but at the time of writing had retracted to 16c.
“Investors should definitely take profits first and think later,’’ Hemming says.
“That’s especially the case with the mining sector where (a downturn) hits you in the face before you know it.’’
The sprawling biotech sector is always a fertile ground for speculative cash, but suffers a hit-and-miss reputation as even late-stage drug developers face regulatory or marketing hurdles. The resources small end remains largely unloved, the result of lower commodity prices, a capital drought and a generally constrained investor appetite for risk.
Once again though, the experience of hot WA nickel explorer Sirius Resources and runaway African graphite play Syrah Resources show that stellar returns are possible.
Mind you, punters need to sift the dreamers from the doers.
According to data compiled by Minotaur Resources, as of mid-June there were 537 ASX listed resource stocks with a market cap of less than $25m.
Of these, 465 held less than $3m of cash — enough for a few decent board lunches but few decent assays.
Resources specialist Peter Wright, of the Brisbane-based Bizzell Capital, sees a nascent recovery. “You are seeing volume back in the space and some speculative appetite returning,’’ he says.
“There’s a growing willingness to look at these stocks again.’’
Wright notes that having cratered to 1900 points in the June 2013 quarter, the small-resources sector is holding above 2000 points.
“You don’t have the frenzied enthusiasm to get projects to market at any cost,’’ he says.
Wright says the market takes a “binary” view of resources: it’s either boom or bust.
“But there’s a middle ground and China growing at 7 to 8 per cent (GDP) is still material, especially as it’s off an ever higher economic base.’’
McCrae also maintains faith in a resources sector.
His zeal is understandable, given Proactive picked LNG and graphite stars Triton Minerals (up 800 per cent in three months) and Kibaran Minerals and Metals of Africa (both up 400 per cent).
“While it’s easy to write off small caps as being dogs over the past year, there have been a number of ‘multi baggers’,” he says.
“While industrial small caps have done better than micro resource stocks, opportunity is knocking.
“Companies are being rewarded for successful exploration from investors — that is the key difference or them now.’’
For mining service stocks, there’s the prospect of a more grinding recovery.
According to Clime Investment Management chief investment officer John Abernethy, the capital investment cycle is heading from a peak, where it accounted for a whopping 8 per cent of the country’s GDP, to 2.3 per cent.
“It’s a pretty big negative for the small cap index,’’ he says.
“With mining services companies, there’s not a lot that gets us excited.’’
D’Amato says global investors have been chasing stocks with high liquidity rather than the small caps, which can have volatile share movements on small volumes.
“Typical small cap companies may also have a single income stream, relatively limited access to financing … and low or no dividend growth as cashflow is limited.’’
It’s not all bad: of the 197 small-companies index constituents, only 65 stocks experienced share price declines and the rest had flat to positive share-price growth.
“This proves that gems can be found in the sector by the smart and informed investor,’’ he says.
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