Small caps for the long-sighted

Buying small- and mid-cap stocks is a hard argument to make in a safety-first market, except for two big factors: the small-cap sector will be the first to benefit when the next bull market finally arrives and portfolio outperformance will come from stocks outside the top 100.

That does not mean investors should dive into small- and mid-cap stocks in 2012-13. Capital preservation strategies remain paramount in a slow, grinding sharemarket recovery that may take years rather than months to reach the previous peak of 6853 on the All Ordinaries index in November 2007.

In this scenario, more of the total shareholder return will come from dividends rather than capital growth, which is why high-yielding stocks such as Telstra have been popular this year. Small-caps usually yield less than blue-chips because they reinvest more capital to fund growth.

The other red light for small-caps in 2012-13 is risk aversion. Persistent high sharemarket volatility is a given this financial year: Europe is a mess, the US economic recovery is anaemic and China is slowing more than expected. Such conditions are hardly conducive for a small-cap rally.

These trends are causing small caps to underperform blue-chips. The S&P/ASX Small Ordinaries index, which includes stocks ranked 101 to 300 by market capitalisation, shed almost 15 per cent on a total return basis (including dividends) in 2011-12. The S&P/ASX 200 lost 7 per cent.

Micro-cap stocks are faring even worse. The S&P/ASX Emerging Companies index, which includes stocks mostly outside the top 300, is down about 17 per cent in the year to June 30. Small resource stocks have been especially hard hit after rallying in recent years.

Not surprisingly, the big trend has been money flooding into cash and high-yielding defensive blue-chip stocks, such as utilities. As the global economy improves, smart investors will allocate more of their portfolios to more growth stocks but it is still too early to be bullish about the small-cap sector.

Rather than get hung up on market timing, a better strategy in 2012-13 is to focus on portfolio construction and buying the best quality small- and mid-cap stocks during sharemarket downturns.

Excluding cash, investors can use a core-and-satellite strategy where the core component of their portfolio is based on blue-chip stocks and fixed interest and the satellites include small-cap managed funds or holding small- and mid-cap stocks directly.

They might, for example, hold an exchange-traded fund (ETF) over the S&P/ASX 200 index for low-cost exposure to blue-chips, a few international-focused ETFs for global equity exposure and some new fixed-interest ETFs for exposure to government and corporate bonds. Adding a small allocation to gold through an exchange-traded commodities (ETC) fund further improves diversification.

With the portfolio core based on indexing, where a market return is sought, investors can focus on holding fewer active investments that provide alpha, or a return greater than market. This combination of ETFs, higher-yielding interest rate securities, small-cap managed funds or a handful of high-quality small-cap stocks, makes a lot more sense than holding a large collection of stocks directly.

Put another away, it means focusing on fewer active investments and gaining more of the portfolio return through low-cost indexing in 2012-13.

Combining index and active investing also lowers portfolio transaction costs, improves diversification and gives investors more time.

The next question is where to find active exposure in 2012-13. Blue-chips have a core place in every portfolio and large-cap funds that consistently outperform are great investments.

The trouble is, the top 100 stocks have rising correlation, meaning they tend to move up or down in the same direction. And most large-cap managed funds underperform their index after fees.

In contrast, small-cap stocks have less correlation and most small-cap fund managers outperformed their benchmark index over five years to June 30, 2011, according to Standard & Poor’s.

That strengthens the case to use index funds for the top 20, 100 or 200 Australian stocks and seek higher returns in the small and mid-cap sectors, where there are more pricing anomalies.

Of course, every investor is different and the above strategy is one of many. Also, investors who are confident their large-cap fund managers can consistently outperform the benchmark index after fees should use such funds for active exposure to blue-chips. Unfortunately, such managers are rare.

Investors must then decide whether to gain their small-cap exposure through funds or stocks. Australia has some terrific small-cap funds but holding too many ETFs and funds can give too much diversification, create stock duplications and limit returns. Having a concentrated portfolio of small-cap stocks, assuming most of the portfolio is well diversified, provides scope for higher returns.

Choosing the right small-caps is never easy in a volatile market. The temptation is to buy fallen stocks based on where they have come from, rather than where they are going. A huge trap in 2012-13 is being seduced by past share prices and artificially low price-earnings (P/E) multiples and high yields because these metrics are only as reliable as the earnings forecasts that underpin them.

There are still far more earnings downgrades than upgrades from sharebroking analysts and more are likely, given a slowing global economy and Australia’s patchy two-speed economy. Analysts collectively have been too bullish in their forecasts. As earnings forecasts fall, P/E ratios rise and stocks that looked cheap are shown to be an illusion.

In this market, it makes sense to pay a little more for high-quality small-cap stocks that have greater earnings visibility than chasing seemingly cheap stocks that have less reliable earnings growth and are value traps rather than good value. Buying stocks on the basis of a turnaround is a high-risk strategy, given so few corporate rescues work as expected. Hoping for a takeover is just as risky.

Instead, stick with the best-quality small stocks that have clear sustainable competitive advantages, a so-called “economic moat” that defends their market position, recurring and more visible earnings growth, some dividend yield and the ability to grow if the global and local economy deteriorates.

This thinking informs the 10 small and mid-cap stocks chosen as BRW’s picks for 2012-13. For example, the online “portal” stocks such as REA Group and Carsales.com will continue to grow by taking market share from their print media competitors. Super Retail Group has shown it can grow during weak retail conditions, and is well positioned to benefit as things improve.

Others, such as business information group SAI Global and salary packager McMillan Shakespeare, have recurring income and the ability to grow faster without needing high capital investment. They have more defensive growth and still look reasonable value after strong gains in the past two years.

The best quality stocks usually trade at a premium and the challenge is buying them when they offer better value. The seasonally weak September/October period may provide such an opportunity as investors focus on the next big worry: the so-called US “fiscal cliff” as several US tax cuts expire.

Small-cap investors that follow this approach will need a medium-term perspective: the market still needs to grind higher and absorb more bad news, at least for another 12-18 months, before the bulls find their legs.

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