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 have Australian living standards 'fallen' and how do we fix it?

For the last few years there has been much talk of a 'cost-of-living' crisis in Australia and of 'falling living standards'. Lately this has flared up again with the pickup in inflation resulting in a renewed fall in real wages.

Will you run out of money in retirement?

Fear of running out has become a defining retirement anxiety. Why do some retirees die with substantial wealth while others deplete their nest egg? Evidence suggests the answer is more complicated than we think. 

Four options for an income investor’s next dollar

What if Australia’s golden age of dividends is ending? Rather than overhaul your portfolio, it may be worth considering where new capital can work harder. I discuss four income strategies and the trade-offs behind each.

The investment that sidesteps the new tax traps

Tax rules have changed, but many investors are still using yesterday’s strategies. Insurance bonds may offer advantages for those seeking greater control, tax efficiency and certainty about their wealth.

Welcome to Firstlinks Edition 674 with weekend update

What begins as appetite, grows into excess and ultimately ends in spectacle. Millions of investors just discovered this the hard way.

  • 6 August 2026

Testamentary trusts have secured the CGT exemption

Treasury’s latest CGT reform draft delivers a win for testamentary trusts and deceased estates, exempting estate-derived gains from the 30% floor. However, questions on death and divorce rollovers remain unresolved.

Latest Updates

Retirement

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.

SMSF strategies

Who really loses from the SMSF borrowing ban?

The ban on borrowing to buy residential property inside a self-managed super fund was framed as closing a loophole for the wealthy. Yet ATO data suggests its effects may be felt more heavily on members with moderate balances.

Investment strategies

The investing rule that explains the next market crash

What if investment success depends less on picking the right assets and more on understanding the decisions of other investors? A principle borrowed from game theory offers a different perspective on markets.

Investment strategies

Gold: should you own the metal or the miners?

Gold is back in the headlines but investors may be asking the wrong question. Before deciding where prices are headed next, it's worth considering whether the investment you choose will deliver the outcome you're actually seeking.

Fixed interest

Global bonds markets are hiccupping

For decades, investors looked the other way as government debt ballooned. But a reckoning may be beginning. Bond markets are stirring and the consequences could reach far beyond markets into everyday life.

Property

Why investors are looking beyond traditional property sectors

A little-known corner of the property market may be quietly benefiting from powerful demographic and healthcare trends. Could this specialised sector offer investors something increasingly difficult to find: enduring demand?

Retirement

Retirement in reality - 6 months in

Is retirement really an identity crisis, or is something else at play? New insights challenge conventional thinking and reveal why some retirees struggle to fully embrace life after work.

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.