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.

 

  •   3 July 2019
  • 1
  •      
  •   

RELATED ARTICLES

Five reasons Australian small companies are compelling investments

Right asset class, wrong index: the trap in Australian small caps

Why have small cap stocks underperformed?

banner

Most viewed in recent weeks

Why spending more in early retirement can improve lifetime income

Conventional wisdom encourages retirees to preserve superannuation. But if those likely to qualify for the Age Pension later in life spend a little more today, it may deliver higher lifetime income and a more stable retirement.

Is it time to bail on Australian stocks?

For generations, Australian investors have backed banks, miners and dividends. But has that loyalty come at a cost? A look at the numbers raises an uncomfortable question about where future returns will come from.

Meg on SMSFs: What do we think about reversionary pensions these days?

Reversionary pensions have long been a staple of SMSF estate planning, but are they still the best option? Meg Heffron revisits a once-clear favourite and asks whether changing super rules have shifted the balance.

Testamentary trusts survived the trust tax. The drafting battle has just begun.

The fight over testamentary trusts looked settled. Then the draft legislation arrived. Hidden in a technical detail is a question that could force many families to rethink wills they thought were already future-proof.

How does the 4% rule stack up?

The 4% rule has long been retirement's gold standard. But after a difficult period for investors, fresh analysis suggests a more conservative approach may significantly improve the chances of making savings last.

The new capital gains tax trap for your portfolio

Investors have long accepted one portfolio rule without much question. A major tax shift could change that calculation entirely, forcing difficult trade-offs between risk, discipline and an overlooked cost lurking beneath.

Latest Updates

Exchange traded products

It’s time for LICs to die

A high-profile dividend cut and a prominent fund manager’s apology have reignited a long-running debate. If investors can access similar exposures more cheaply and efficiently elsewhere, what exactly is keeping LICs alive?

Taxation

Will investors be better or worse off under new housing tax changes?

Housing tax reforms have sparked warnings of market turmoil and promises of greater fairness. But after modelling nearly two decades of property data, the results suggest winners and losers may not be who many investors expect.

Retirement

Three considerations before reshaping your legacy plan

Many retirees hope to leave a legacy. Proposed trust tax reforms could force families to rethink. The question is not how much to leave behind, but whether today's inheritance plans will still make sense as circumstances change.

Investment strategies

Why experienced investors still get markets wrong

Retirement is approaching. Markets are noisy. And every headline seems to demand action. The biggest investment risk isn't fear, greed or market volatility, it often arrives disguised as research and sensible risk management.

Shares

Why pay more for less?

Conditions were stacked in favour of professional investors in 2026. Most still fell short, raising questions about where investors should look for value. Meanwhile, an alternative strategy continued to make its case.

Investment strategies

Bleeding air out of the bubble

Equity valuations have fallen sharply over the past year, yet investors have largely been spared the volatility and losses that typically accompany a de-rating. What explains this unusually orderly reset? Here are five key drivers.

Strategy

Has AI gone rogue?

We worry about AI becoming conscious. But what if consciousness isn't the issue? The more unsettling possibility is a machine capable of pursuing objectives relentlessly, without motives, emotions, or awareness of any kind.

Sponsors

Alliances

  • ASA-Logo-RGB-ActiveGreen-web.png

© 2026 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. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. 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.