Australia’s small cap shares have rarely failed to capture investors’ imaginations, not least for their ability to generate eye-watering returns when company narratives become reality. Since the start of 2016, sustained growth from small industrials combined with a rallying mining sector have produced remarkable performance for investors willing to move outside Australia’s biggest names.
Now, confronted with a rolling bear market, small cap managers are experiencing a period of pain and possibly some introspection. The past three years have taught us that dreams can be kept alive, even if they don’t always come true. Looking back, it’s fair to say that small cap outperformance was not a broad-based phenomenon. But even in an environment of elevated volatility and with market risks tilted to the downside, this does not necessarily mean that opportunities have dried up.
Taking a look at Lonsec’s peer group of small cap managers, past returns have shown significant dispersion due to a range of different sector and stock exposures. As we now know, the small cap rally was led by a narrow group of shares over the preceding six months to January 2018, and this trend continued through the second half of 2018, albeit with increased volatility.
The range of small cap fund manager returns has been wide
(returns to October 2018)
Returns based on Lonsec’s small cap fund manager peer group
For the 2018 financial year the Small Ordinaries Index returned +24% (wouldn’t that be nice!) but this is not representative of the performance of the broad range of small cap stocks. Closer analysis reveals that 20 stocks delivered 60% of these gains, while the median stock in the index returned a more down-to-earth +9% for the year.
These top 20 hot stocks that drove the small cap index over the last 12 months are essentially companies with exposure to three themes which have dominated small cap strategies. That is, stocks exposed to the Chinese ‘Daigou’ distribution channel, resource stocks exposed to the emerging battery technology theme, and emerging technology companies.
Small cap darlings have been driving performance (FY19 P/E ratio)
Source: Lonsec, Bloomberg
Looking at the largest 20 shares in the small cap index, eleven had a P/E ratio of over 20x and the average P/E of this group was 30x. Among these were a number of market darlings which have delivered strong returns for investors but due to their popularity saw their valuations pushed ever higher. Prior to the start of Lonsec’s annual review of small cap managers, the FY19 P/E ratio of the ASX Small Ordinaries Index was in excess of 19x versus the historical average of around 13x, indicating a large part of the index gains have come from multiple expansion more so than earnings growth.
Small cap sectors have seen significant divergence
(period returns to end November 2018)
Source: Lonsec, FE
Most recently, those fund managers that have held up better than the peer group average (in the face of significant declines in share markets) have done so due to a significantly higher cash weighting in their portfolios. Managers generally anticipate volatility in equity markets will remain elevated in the medium term. As the price of risk is reassessed, valuations remain lofty and earnings growth remains elusive.
But all is not lost. Managers continue to see a broad range of attractive investments across the smaller company sector, with funds able to provide exposure to a number of niche opportunities and fast growing emerging trends, including the impact of growth in IT spending and the transition to cloud based computing, as well as quality domestic franchises expanding into larger global markets.
Add to this the disruption we have seen in financials as new business models compete with established players, along with the recovery in certain commodity markets from cyclically depressed levels, and there still plenty of themes to capture investors’ attention. The rally in small caps may be over for now, but opportunities remain for those managers who can identify the emerging trends.
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