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Published 06 December 2012 05:15, Updated 07 December 2012 19:23
Permanently higher interest in small-cap investing seems inevitable in this market. As it becomes harder to outperform the sharemarket consistently using large-caps, investors are searching for small and mid-cap stocks to boost portfolio returns.
Falling interest rates and more signs the Australian sharemarket has bottomed support the case for increasing small-cap equity portfolio allocations. Better-quality small industrial and finance stocks often led market rallies when investors bet on an improving economy.
That does not mean dumping blue chip stocks with reliable yields or rushing to speculative plays. The focus should be selectively adding shares outside the top 100 by market capitalisation, or finding well-preformed managers to do that.
Two initial public offerings (IPOs) opened in November for listed investment companies (LICs) that specialise in small and mid-cap investing. NAOS Asset Management wants to raise up to $50 million for its NAOS Emerging Opportunities Company; Contango Asset Management wants up to $200 million for the Contango Mid-Cap Income Fund.
Plenty of unlisted managed funds that specialise in small-cap stocks have beaten the S&P/ASX Small Ordinaries Accumulation Index over five years – a terrific performance. Several exchange-traded funds (ETFs) over small-cap indices have also been launched, although in my view there is a weaker case for using index funds for small-cap exposure.
The LIC structure is well suited to small-cap funds. Unlike open-ended unlisted managed funds, small-cap LIC managers are not forced to sell stocks to meet heavy fund redemptions, or buy them when money flows in. That can hurt performance and distract managers.
The downside is many LICs trade at a seemingly permanent discount to their net tangible assets (NTA) because investors doubt the manager’s performance or ability to pay dividends. After solid gains this year, the LIC sector now trades almost at parity to NTA but the risk of big discounts is a concern.
The NAOS and Contago offers will be a good test of investor appetite for small-cap investment products and of the renewed interest in LICs. NAOS and Contago are well established and strong performances from small-cap LICs, such WAM Capital and Cadence Capital, have attracted interested in this part of the sector.
NAOS Asset Management, in particular, has a good long-term record in its unlisted NAOS Emerging Companies Long Short Fund. Morningstar ranked the hedge fund as one of the top five equity funds in Australia over three, five and seven years to September 2012. Like that fund, the NAOS LIC will invest mostly in micro-cap technology, life science, telco and mining stocks.
I asked NAOS managing director Sebastian Evans about the top holdings in the NAOS Emerging Companies Long Short Fund, which has a knack for picking interesting micro-cap stocks that give investors exposure to fast-growth industries.
Evans’s first pick, Acrux, is among the better-known life science stocks. US pharamaceutical giant Eli Lilly is commercialising Acrux’s underarm testosterone treatment, Axiron, and targeting a multi-billion dollar global market. After strong gains in 2010 and 2011, Acrux shares dived from a 52-week high of $4.77 to $2.77 amid patent delays in the US and product rebate issues.
Evans believes the sell-off has been overdone and expects Acrux shares to head back above $4 within a year or two as Eli Lilly more aggressively markets Axiron worldwide. Valuation risks are sharply lower at current prices and Acrux’s Pooled Development Fund status means generous tax concessions are available.
Among mining stocks, Evans favours Atilla Resources, which has soared from a 52-week low of 13¢ to 95¢ after promising exploration results at its Kodiak hard coking coal project in Alabama. Coal exploration stocks are badly out favour on lower coal prices and fears that many projects will be delayed or abandoned because of funding and infrastructure challenges.
Evans likes Atilla’s exposure to hard coking coal, a premium variety, and its proximity to well-established plant and rail infrastructure. Large infrastructure costs bedevil many remote bulk-commodity projects that have to invest in expensive transport access.
Atilla’s Kodiak resource has an inferred resource of 81.1 million tonnes that complies with the Joint Ore Reserves Committee (JORC) code, capital costs should between $30 million and $40 million and Evans expects the project to be in production within two years. Even after strong share price gains this year, Atilla is capitalised at only $32 million; its valuation compares favourably with the $244 million Bathurst Resources, which has a similar size, although more advanced, resource.
Evans also rates Sierra Mining for its promising gold-copper Mabilo project in the Philippines, which is near ground held by the successful Medusa Mining. As junior explorers, Sierra and Atilla suit experienced speculators comfortable with higher investment risks.
This is my last column for 2012. Thanks to all readers for their continued support this year and have a safe summer holiday. This column returns on January 24.