Investing in Australian small cap equities - There's a better way.

In a quest to diversify portfolios from the concentration biases found in the large cap Australian equities market, we often observe portfolio constructors allocate a defined (and often static) weight to Australian small cap investments. At a glance this intuitively makes sense, because we expect to achieve superior diversification by investing outside the large cap stocks, and because of the belief smaller companies will have stronger earnings growth opportunities. But these views may be flawed.

The small cap index is a dud index

Over the long term the small cap index has underperformed the large cap by around 2.8%p.a. (since 1990) and has done so with 25% higher risk. But that’s not to say there are not significant opportunities in small caps from time to time with the performance differentials between small and large cap Australian equities significant over the short term. This indicates that actively managing the rotation in and out of the small cap market should be a consideration, and timing is important.

It’s the index construction that provides risks and opportunities

In Australia, the lack of a venture capital industry results in listing rules that do not consider a business’s profitability or financial viability (as opposed to other global markets) results in times where our market is built around a large number of non-revenue or profit generating mining companies. For small cap equity managers, when one of the most effective portfolio construction methods is to avoid the losers, is it reasonable to pay an active or performance fee based on this market anomaly? Our belief is that while the average active manager in Australian small caps has been able to outperform the index, this is due in a large part to the inefficiencies in the index construction. On average, small cap managers earn a fee 60% higher than that for large cap portfolios. While at a base fee level there is some justification for this given the relative size of assets that can be managed in each market cap segment, we would suggest investors should be wary of the potential for large performance fees to be accrued versus the poorly constructed small cap index.

A broadcap flexible approach should be adopted

We believe valuation is a strong indicator of future returns and this belief is supported by analysis of starting point Price to Earnings ratios (P/E) and the subsequent 3-year performance. What we actually find using historical data is that there is a distinctive trend towards higher valuations in small cap leading to subsequent underperformance relative to large cap. Interestingly, higher valuations in large caps don’t necessarily lead to underperformance of small caps. At present, small cap P/E are relatively high compared to history (at 18.7x) and higher than the large cap market. On this analysis it clearly makes sense for investors to explicitly consider the valuation differences between small and large cap stocks in making their investment allocation decisions. Not all investors have the skill and tools to either monitor the timing of asset allocation or the ability to change the incumbent investments. We believe the decision and implementation for actively managing Australian equities is best made by a broadcap investment manager with skills to understand when the opportunity is right across the full market cap spectrum (large, mid, small and micro-cap sectors). In addition, having an investment manager with skills and resources to research opportunities across the full spectrum ensures stock specific ideas can be prioritised rather than esoteric ideas coming from a specific cut off point in a benchmark.

Benchmarks and active management

An objective look at the opportunities presented across the small and large cap Australian equities market suggests that segmenting the allocation by market cap (as defined by some arbitrary stock number) isn’t necessarily the best way for investors to manage their portfolio. While investors may wish to consider a bias towards smaller caps to take account of the greater economic diversity from this part of the market, we present a number of reasons why an alternative broad cap exposure is a different way to structure a client’s aggregate Australian equities exposure versus separate small and large cap portfolios. In particular we conclude that:

1.            The small cap index is poorly constructed and suffers from significant structurally lower long-term performance, higher risk and poorer earnings growth characteristics

2.            Active management of this part of any Australian equity exposure is both essential and rewarding

3.            The appropriate benchmark against which performance should be measured and fees calculated is a broader market index or the large cap index, rather than a specifically small cap index as this is more representative of the opportunity set and removes the bias created by an arbitrary index cut-off

4.            The performance differentials between small and large cap stocks, while biased in favour of large cap, have shown significant historical variability and this represents a greater opportunity for investors with broad cap research capabilities to add value.

How we manage

The Schroder Australian Equity Opportunities Fund is a more diversified broad cap approach with a significant exposure to stocks outside of the top 100. As of October 2017, the Schroder Australian Equity Opportunities Fund had 35.7% of its equity exposure outside of the ASX 100.

The structure of our unconstrained strategy (‘Schroders Equity Opportunities Fund’) is premised on our view that relative size as the single determining factor behind the relative attractiveness of a stock has a weak linkage to the economic fundamentals of a business, and the relative investment merits of that company. Our approach is not wedded to either large or small caps, but rather takes an active exposure to all capitalisation segments of the market, and not simply the structural bias inherent in, say, a standalone small strategy. As such, using the full breadth of the universe and departing from benchmark weights based upon assessment of investment merit continues to be a potential source of alpha for active investors.

Our unconstrained approach is also manifested in the way we structure our team where stock coverage is allocated to each analyst on a sector basis and extends down the market cap spectrum to include large, mid, small and micro-cap stocks. We believe this integrated approach to research is superior to a market cap based approach as it enables deep industry knowledge to be shared. The overriding factor in dictating stock inclusion and position size is the desire to maximise exposure to high quality businesses at attractive valuations. Avoidance of both poor quality and overvalued businesses should enable returns above those of any size-determined indices (either large or small) over the longer term.

For more details download the full report authored by Greg Cooper, CEO Schroders Australia