Best small-cap ideas

Published 25 October 2012 04:09, Updated 25 October 2012 05:01

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Winning the game of market musical chairs is the real battle with long-term investing. Knowing when to move more funds from cash to fixed interest to blue-chip stocks and small caps ultimately creates much greater value for portfolio investors than direct stock picking.

But getting the big asset allocation shifts right in portfolios confounds even the best investors because markets rarely follow an orderly script. The only certainty is that too many retail investors are too slow with so-called portfolio tilts, which lift or reduce allocations towards certain assets relative to the desired weighting.

Consider market trends this year. Investors who have held too much cash in bank term deposits for too long face puny returns of 2-3 per cent this year after inflation. Those who moved funds into higher yielding defensive blue-chip stocks, such as Telstra, have enjoyed double-digit shareholder returns. Those who bought bank stocks rather than invest in bank products did much better again.

Stronger returns in the next 12 months could come from holding blue-chip growth stocks that have greater leverage to improving global economic growth and better prospects for share price gains, albeit with low yield. Before long, the smart money will be invested more in small- and mid-cap stocks in anticipation of rising investor risk appetite, while most investors are not even thinking about it.

I’m not suggesting that retail investors take big punts on the next hot market and jump between asset classes; that is speculating rather than investing. Owning the best quality blue-chip companies with decent, sustainable yields should be a permanent feature of outstanding portfolios, not a fashion.

But there is a case to add more growth assets to portfolios and pay greater attention to small- and mid-cap stocks over the next 12 months in anticipation of the next bull market.

My past two columns have laid out a view of the sharemarket bouncing between 4000 and 5000 points before stronger gains next year. If that view is correct, it is time to add more small- and mid-cap Australian equity exposure to portfolios, for they often rally first.

How to do that depends on your risk tolerance and investment experience. Portfolio investors might use an exchange-traded fund (ETF) to achieve a similar return to the S&P/ASX 200 Small Ordinaries index. State Street, iShares Australia and Vanguard each offer an Australian small-cap ETF through the ASX; Vanguard is the cheapest, with annual fees of 30 basis points.

These ETFs appeal to conservative investors who are happy with the market return from small-cap Australian stocks, want diversified exposure and low fees. I struggle to get excited about small-cap ETFs when this is one of the rare markets where most active fund managers have shown they can outperform the Small Ords index consistently over five years, according to Standard & Poor’s research.

A better strategy is using an ETF to gain index exposure over the top 20 or top 200 ASX stocks by market capitalisation, where sustained outperformance is much harder to achieve and use active managers for small-cap stock exposure.

When choosing small-cap managers, it is hard to go past those with good long-term performance, such as the BT Smaller Companies Fund, the Celeste Australian Small Companies Fund or the Pengana Emerging Companies Fund.

The Smallco Investment Fund has excellent returns over one and three years thanks to its higher weighting of internet stocks such as REA Group and Carsales.com.

Listed investment companies that specialise in small-cap stocks, such as WAM Capital and Clime Capital, have also had good returns in their underlying funds. Wilson Asset Management in particular has been a standout small-cap fund manager; since inception in 1999, WAM Capital has outperformed the Small Ords Accumulation index by an average 10.3 per cent each year. Buying a listed investment company can offer extra value if it is trading at a discount to its net tangible assets.

Investors seeking higher risk and more concentrated returns should invest directly in small- and mid-cap stocks. In July, this column nominated 10 investment grade stocks to watch in 2012-13: Carsales.com, REA Group, Super Retail Group, ARB Corporation, Monadelphous Group, IRESS, SAI Global, McMillian Shakespeare, InvoCare and Navitas. Several of them have rallied in the past few months.

Experienced speculators might delve into micro-cap stocks or those yet to earn profit. I nominated 10 for 2012-13: Perseus Mining, Gryphon Minerals, Buru Energy, Highlands Pacific, Kina Petroleum, GI Dynamics, Reva Medical, Alliance Aviation Services, IMF Australia, and Maxitrans Industries. Car catalogue provider, Infomedia, is another to watch.

The life science stocks have disappointed but exploration stocks such as Gryphon have had good gains in recent months.

Expect small- and mid-cap resource stocks to rally if the market gets a stronger whiff that China’s economic slowdown has bottomed. The S&P/ASX 300 metals and mining index has underperformed the broader market over the past 12 months and may have been sold down too much.

Gold stocks in particular are worth watching, because they have badly lagged gains in the gold price.

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