Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 313

Picking the winners, avoiding the losers

There are many high-quality small companies operating across all areas of the Australian economy. Some of these companies will one day grow into large, mature businesses.

Identifying these stocks at the beginning of their journey provides investors with the potential for significant capital growth along the way. As small companies flourish, revenue and earnings growth are typically expanding at their fastest point in the company’s lifecycle. It is growth that larger, more mature companies would find difficult to replicate.

On the flip side there are, of course, many poor-quality companies in the S&P/ASX Small Ordinaries index. Some will spend years floundering, or fall victim to unfavourable market conditions or poor management decisions. Investing in these companies can result in significant (or total) capital loss.

Therefore, especially in small caps, the key is picking the winners and avoiding the losers.

Dispersion and amplification of returns

One-year share price performance – S&P/ASX 100 Index vs S&P/ASX Small Ordinaries Index

Company total returns of index constituents for 30 June 2018 to 30 June 2019 shown. Source: Bloomberg, 12 months ending 30 June 2019.

The chart above shows the one-year returns of companies in the S&P/ASX100 Index and the S&P/ASX Small Ordinaries Index. Return dispersion and amplification in the small caps universe is higher than in the large caps universe. Note the number of small company stocks which performed extremely well and the number that performed extremely poorly.

Out of 200 stocks in the S&P/ASX Small Ordinaries Index, 50 stocks – or one in four - lost 25% or more, including two that went into liquidation. In contrast, only 12 stocks in the S&P/ASX 100 lost 25% or more over the course of the year.

Dispersion of returns one year to 30 June 2019

Amplification of returns one year to 30 June 2019

Source Bloomberg, CFSGAM. At 30 June 2019. Small caps is S&P/ASX Small Ordinaries index. Large caps is S&P/ASX 100 index.

The amplification and dispersion of returns underlines the critical importance of careful stock selection in small cap investing and the importance of focusing on downside risk.

Given the inherent risks in individual stock selection, why not diversify and mitigate this risk by simply owning the index?

The importance of being active

In addition to the wide divergence of returns, history shows that the larger cap S&P/ASX 100 index regularly outperforms the S&P/ASX Small Ordinaries index and with less volatility. The chart below shows how the small cap index has underperformed the large cap counterpart in the last decade.

S&P/ASX Small Ordinaries Index returns vs S&P/ASX 100 Index returns, 10 years to 30 June 2019

Source Bloomberg, CFSGAM. Cumulative total returns 30 June 2009 to 30 June 2019.

In the S&P/ASX Small Ordinaries index, the negative returns from numerous low-quality companies often erode the value created from more successful businesses. Attempts to mitigate risk by diversifying across the index, for example, via passive investments or low active share, are often not the optimal strategy for investors with regards to the risk/reward outcome.

However, the comparison of returns from the S&P/ASX 100 index and S&P/ASX Small Ordinaries index is too simplistic. The index returns ignore the impact of ‘alpha generation’ that active managers can produce, which can be particularly significant in small caps.

Most stocks in the large cap S&P/ASX 100 index are extensively researched by the professional investment community. They are mostly well known, mature companies with a large shareholder base. Investors like to hold large, mature companies because they are generally considered more predictable and less risky than their small cap counterparts.

In contrast, small companies tend to be less well researched and understood. This provides the opportunity for skilled small cap managers to identify companies that have the potential to be future leaders, and companies that have the propensity to fail. By picking the winners and avoiding the losers, there is potential for significant alpha generation.

Capital preservation is key

To help avoid the losers, small company fund managers should have a strong focus on downside risk and be invested in a concentrated group of quality stocks, which collectively have a better return profile than the index. In aggregate, a risk-aware small cap fund is likely to have a larger allocation towards investments that have a clearly-defined, articulated investment strategy, supported by a strong capital position and a proven and capable management team. The long-term outcome of such strategies is typically a strong return on capital and free cash flow generation.

To show what is possible in this space, the chart below shows the percentage of months the CFS Wholesale Small Companies Fund has performed in rising markets, falling markets, and all markets over a period of 10 years.

Active asset selection, percentage of months outperforming (net) 

Source: CFSGAM. The chart shows the percentage of months the CFS Wholesale Small Companies Fund has outperformed its benchmark (S&P/ASX Small Ordinaries Index). Net returns shown after fees and taxes, between 30 June 2009 to 30 June 2019. Past performance is not an indication of future performance.

The chart shows the Fund is more likely to outperform in down months (78.8% of the time over 10 years), due to the resilience of higher-quality companies during falling markets. It also demonstrates a propensity to avoid the biggest losers when times are bad.

During rising markets, the Fund outperforms less frequently. It does not chase returns or invest in the ‘next big thing’. Performance over multiple investment market cycles has proven the effectiveness of a focus on quality to pick the winners and avoid the losers.

 

Dawn Kanelleas is Senior Portfolio Manager, Australian Equities Small Companies, at Colonial First State Global Asset Management, a sponsor of Cuffelinks. This article is for educational purposes and is not a substitute for tailored financial advice.

For more articles and papers from CFSGAM, please click here.

 

RELATED ARTICLES

Five reasons Australian small companies are compelling investments

Why have small cap stocks underperformed?

banner

Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

Coles no longer happy with the status quo

It used to be Down, Down for prices but the new status quo is Down Down for emissions. Until now, the realm of ESG has been mainly fund managers as 'responsible investors', but companies are now pushing credentials.

Latest Updates

Superannuation

The 'Contrast Principle' used by super fund test failures

Rather than compare results against APRA's benchmark, large super funds which failed the YFYS performance test are using another measure such as a CPI+ target, with more favourable results to show their members.

Property

RBA switched rate priority on house prices versus jobs

RBA Governor, Philip Lowe, says that surging house prices are not as important as full employment, but a previous Governor, Glenn Stevens, had other priorities, putting the "elevated level of house prices" first.

Investment strategies

Disruptive innovation and the Tesla valuation debate

Two prominent fund managers with strongly opposing views and techniques. Cathie Wood thinks Tesla is going to US$3,000, Rob Arnott says it's already a bubble at US$750. They debate valuing growth and disruption.

Shares

4 key materials for batteries and 9 companies that will benefit

Four key materials are required for battery production as we head towards 30X the number of electric cars. It opens exciting opportunities for Australian companies as the country aims to become a regional hub.

Shares

Why valuation multiples fail in an exponential world

Estimating the value of a company based on a multiple of earnings is a common investment analysis technique, but it is often useless. Multiples do a poor job of valuing the best growth businesses, like Microsoft.

Shares

Five value chains driving the ‘transition winners’

The ability to adapt to change makes a company more likely to sustain today’s profitability. There are five value chains plus a focus on cashflow and asset growth that the 'transition winners' are adopting.

Superannuation

Halving super drawdowns helps wealthy retirees most

At the start of COVID, the Government allowed early access to super, but in a strange twist, others were permitted to leave money in tax-advantaged super for another year. It helped the wealthy and should not be repeated.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.