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Harnessing the upside and risks of small caps

Global equity managers have been lining up to create Listed Investment Companies (LICs) recently, but small caps have been underrepresented. While there are pros and cons associated with any investment structure, some of the new breed of LICs benefit from managers absorbing listing costs. In addition, the number and scale of offerings has meant a significant improvement in secondary market liquidity.

LIC structure has benefits … and some risks

Why is the LIC structure appealing, often as the listed alternative to a managed fund?

  • LICs are closed-ended. Once listed, the LIC doesn’t have the cash flow pressures of a managed fund, which must keep cash on hand to manage applications and redemptions. As a result, the frictional cost (direct and indirect costs of executing transactions) is typically lower.
  • Freed of the requirement to keep cash on hand, the manager can be fully invested and focus on investment fundamentals without worrying about cash flow.
  • LICs are companies. Distributions are paid as fully franked dividends, generally a tax benefit for investors. It can also retain earnings whereas a unit trust must pay out all income including capital gains.
  • LICs are transparent. Investors have a better look-through at managers’ holdings than in a managed fund.

On the other hand there are risks and potential drawbacks:

  • Market timing is important for an LIC, because once listed, it cannot raise new funds without going back to the market. If all the proceeds of the initial public offering (IPO) are invested on listing, and the market falls soon afterwards, it can be difficult to re-balance the portfolio without raising new funds. Managing market-timing risk, for example, could mean extending the trade horizon to deploy capital after listing. In our view, six months is an appropriate time to take to invest capital in order to offset market-timing risk.

  • Dividends can only be paid out of retained profits, and it takes time to generate profits and dividends. In some cases investing in an unlisted trust could see earlier distributions to investors. Over time these differences are likely to decrease.
  • LICs may be popular but small caps are less represented than large cap equities. The small cap segment of LICs lacks diversity and scale, and some are sub-scale and have traditionally traded at a discount to Net Tangible Assets. As a result, they have not attracted the breadth of investors necessary to maintain liquidity and keep spreads narrow post-listing, which has curtailed further investor demand.

Investment opportunities in small caps

At the small end of the market, the opportunity for growth is higher. The small cap market tends to be less efficient and the companies are not as well researched as large caps. Companies such as Blackmores, A2 Milk, Domino’s Pizza and Dulux group were once small caps with strong potential, and investors who identified their potential early did well.

Growth aside, some apparently unlovable small caps are turnaround opportunities. In smaller businesses, management teams can have a greater material impact on overall performance.

Success in small caps requires an intimate knowledge of what makes small and medium businesses thrive or fail. For example:

  • Smaller companies tend to be more leveraged to economic growth and changes in the economic climate, which means they can be more volatile with greater price dispersion.
  • Returns from small caps are more dispersed. Over the past 12 months, the dispersion of returns for the top 100 stocks on the ASX was -61% to 98%, whereas small caps ranged from -65% to 1,000%. The aim is to reduce risk by buying companies whose cash flow can support gearing levels or avoid companies where gearing is high.
  • Free cash flow is the make or break number for a small business. Cash flow is the life-blood and key driver of value for any business, small or large, but for small businesses cash flow is arguably more important. It is essential that small companies can self-fund through the cycle, so when a downturn hits they are not reliant on third party funding to survive. The ‘dot.com’ bust was a stark illustration of how a great idea can be worthless when the market loses confidence in the business model and it is unable to fund through that window due its cash burn. The current market is exhibiting similar characteristics.
  • The small caps sector is larger of companies by number and more diverse when compared with the larger cap space. Research coverage is sporadic and of lesser quality, and therefore it’s more important to have specialists in this field.

Managing risk is key for small caps

There’s no such thing as a free lunch in investing. The potential for strong performance comes with potentially higher risk. This is certainly true of small caps, which is why managing risk is of the utmost importance. Sounds simple, but what does it really mean?

Put simply, look at risk first, return second, and this comes back to cash flow. Free cash flow generation through the full business cycle is crucial. We also prefer companies to have low balance sheet gearing to protect against potential downturns.

Valuation matters. We forecast the cash flows and calculate a discounted value of every company we invest in. We look for a margin of safety relative to this valuation. We’re often buying companies at an inflection point, many times in non-consensus situations.

Small caps have much to offer as complimentary to portfolios which are heavily biased to the major banks and a handful of blue chips. Small companies often have a growth potential that is underappreciated by the market for transient reasons. However, their fragmented liquidity, wider spreads and greater volatility mean that for most investors, there are also pitfalls.

 

Matthew Booker is Portfolio Manager, and Adam Lund is an analyst and trader at Spheria Asset Management. This article is general information and does not consider the circumstances of any investor.

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