Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 381

Why caution is needed in Aussie small companies

Small capitalised companies have had a great run since the market bottomed in late March. The S&P/ASX Small Ordinaries Index is up 60% since 24 March 2020, but by contrast, the larger capitalised companies as represented by the S&P/ASX100 index are only up 26.2% (as at 6 October 2020).

The significant outperformance of smaller companies has ignited renewed interest in this sector of the market. Figure 1 shows the two indexes since December 2019.

Figure 1. A wild ride in equities and even wilder ride in smaller companies

Greater returns but with more volatility

Over the last 20 years, smaller companies have outperformed larger companies by almost 0.86% per annum but this outperformance has not been without risk. On average, the volatility associated with small companies is 17% compared to larger companies with 13%.

This is also evident in the beta (a measure of volatility in terms of the overall market, which has a beta of 1 or 100%) of the small company index averaging 114%, as shown below.

Figure 2. Longer term return and risk characteristics from Australian small and large companies

Smaller companies have had a great run in the last six months but a look at the long term puts that outperformance into some context.

Figure 3 illustrates the journey for the last 20 years. Smaller companies have had periods of significant outperformance, which are historically followed by periods of underperformance. Depending on when you invest, your experience could be quite varied.

Figure 3. Periods of outperformance have historically been followed by periods of underperformance

Valuations are rich in absolute and relative terms

On average, over a longer period of time, we find the smaller capitalised companies tend to trade at a slightly higher price to earnings (P/E) multiple and generate slightly lower yields. But this tends to be volatile, as during risk-on periods they can trade at much higher multiples, whereas during risk-off periods, they can trade at below average multiples.

It is entirely possible that the economy will recover and many company earnings will return to pre-pandemic levels, but if they don't, then the small company sector of the market is more at risk of disappointment. From a relative yield perspective, the smaller companies are not as expensive as is implied by earnings multiples.

Figure 4. Smaller company valuations

Watch out for overly optimistic earnings

For smaller companies compared with larger companies, the investment community is usually overly optimistic on earnings. In the last 20 years expected growth for the next 12 months has averaged +21.1% and yet on average this group of companies has only delivered +13.2%. By contrast, the expected growth for larger companies is expected to be lower at only +9.4% and has only delivered +6.8%. It's a much smaller earnings disappointment compared to smaller companies. In both cases, analysts’ expectations have been overly optimistic but in the case of smaller companies, this optimism is exaggerated.

As investment managers that focus on quality, value, improving outlook and lower volatility, we tend to invest in less volatile companies that have not been priced for excessive growth. That does not mean we will not invest in smaller companies if they are expected to provide the right mix of return for risk.

Indeed, as Figure 5 below highlights, we currently own many companies outside the top 50 but within the top 200, but our active weight in these companies changes.

Figure 5. State Street Australian Equity Fund – Active weight to different sized companies since inception^

 

Currently, valuations are stretched for the market and are especially stretched to the smaller end of the index. Most of this has happened in the last six months as investors have been willing to price a strong recovery in earnings.

 

Bruce Apted is the Head of Portfolio Management – Australia Active Quantitative Equities, at State Street Global Advisors. This general information has been prepared without taking into account your individual objectives, financial situation or needs and you should consider whether it is appropriate for you. 

 

RELATED ARTICLES

Longest positive run for Australian shares since WWII

Social media’s impact is changing markets

Boring can be beautiful when investing

banner

Most viewed in recent weeks

Unexpected results in our retirement income survey

Who knew? With some surprise results, the Government is on unexpected firm ground in asking people to draw on all their assets in retirement, although the comments show what feisty and informed readers we have.

Three all-time best tables for every adviser and investor

It's a remarkable statistic. In any year since 1875, if you had invested in the Australian stock index, turned away and come back eight years later, your average return would be 120% with no negative periods.

The looming excess of housing and why prices will fall

Never stand between Australian households and an uncapped government programme with $3 billion in ‘free money’ to build or renovate their homes. But excess supply is coming with an absence of net migration.

Five stocks that have worked well in our portfolios

Picking macro trends is difficult. What may seem logical and compelling one minute may completely change a few months later. There are better rewards from focussing on identifying the best companies at good prices.

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?

Six COVID opportunist stocks prospering in adversity

Some high-quality companies have emerged even stronger since the onset of COVID and are well placed for outperformance. We call these the ‘COVID Opportunists’ as they are now dominating their specific sectors.

Latest Updates

Retirement

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?

Interviews

Sean Fenton on marching to your own investment tune

Is it more difficult to find stocks to short in a rising market? What impact has central bank dominance had over stock selection? How do you combine income and growth in a portfolio? Where are the opportunities?

Compliance

D’oh! DDO rules turn some funds into a punching bag

The Design and Distribution Obligations (DDO) come into effect in two weeks. They will change the way banks promote products, force some small funds to close to new members and push issues into the listed space.

Shares

Dividends, disruption and star performers in FY21 wrap

Company results in FY21 were generally good with some standout results from those thriving in tough conditions. We highlight the companies that delivered some of the best results and our future  expectations.

Fixed interest

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.

Investment strategies

Seven factors driving growth in Managed Accounts

As Managed Accounts surge through $100 billion for the first time, the line between retail, wholesale and institutional capabilities and portfolios continues to blur. Lower costs help with best interest duties.

Retirement

Reader Survey: home values in age pension asset test

Read our article on the family home in the age pension test, with the RBA Governor putting the onus on social security to address house prices and the OECD calling out wealthy pensioners. What is your view?

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.