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Investing at the smaller end of the market

Broker reports editor |  01 May 2014  |  Investing

 small end Self managed super investors tend to steer clear of small companies on the stock exchange, which are known as "small caps". That is, they have a small capitalisation: the combined value of the shares is low. But for diversification reasons, they should be considered. It is possible, for example, to invest in small cap indexes, if investors want to stay away from the risks associated with one particular company.

Most analysts are saying the share market is fairly fully priced and so finding value is difficult. But small cap stocks have underperformed recently, which might open up opportunities. When something underperforms it is possible that it may come back to the pack. The underperformance may even be a result of self managed super fund investors, who greatly prefer the high dividend paying big companies.

UBS notes this, but does not advise rushing in:

"Australian small caps have significantly underperformed large-caps recently, despite an improvement in the domestic macro environment – which has traditionally been supportive of small cap outperformance. While small caps are currently trading (on a P/E basis) at a discount to large caps, this discount is currently in line with long-run trends. The Small Industrial P/E discount reflects the higher 'cyclicality' of the small cap universe compared to the large-cap universe. Nevertheless, Small cap cyclical sectors appear to be trading at a discount to their large cap counterparts."


UBS says the alpha of the small caps -- their relationship to the market average looks positive. That is, they are probably undervalued compared with the average for the overall market. It suggests their beta -- volatility and short term mis-pricing -- is not such a feature. This suggests that there are not a lot of short term trading opportunities. It is more that the overall sector is undervalued:

"Small caps have underperformed large caps on a very long term view. However, small caps appear to provide relatively more scope for alpha relative to large caps, as suggested by the higher volatility of small cap stock returns relative to large cap stock returns, and as demonstrated by the strong outperformance historically of small cap managers.
Key Small Cap Stock Picks
Key small cap stock picks include: Automotive Holdings, Cover-More, Envestra, FlexiGroup, GWA Group, Nine Entertainment Company, Premier Investments, Super Retail Group and Vocation Limited."




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