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Is there value in small and mid-caps?

Paul Rickard
Thursday, August 01, 2019

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The share market might be hitting all-time highs, but investors in small and mid-cap stocks aren’t popping champagne corks. For the 12 months to 30 June, the market has returned 11.6%, including dividends. But for small caps, it is only a measly 1.9%. Midcaps are doing marginally better, with the Midcap 50 index (which covers the performance of stocks ranked 51st to 100th  in market capitalisation) up by 3.7%.

Normally, strong rallies on the share market are led by the cyclical stocks that get an earnings boost as economic conditions improve, turnover rises, and profits grow. These tend to be concentrated in the small and mid-cap parts of the market.

But the rally in calendar 2019, which sees the market up by 21% in price terms and almost 24% when dividends are included, has been driven by interest rates, iron ore and technology. The first two factors have played strongly to the fortunes of the top stocks.

Lower interest rates has been the most important factor. This started when the US Federal Reserve used the word “patience” on 20 December last year and expectations of three US interest rate increases turned into talk of two or three interest rate decreases. And our local Reserve Bank followed suit and cut interest rates in May and July due to concerns about the economy and unemployment. So called “bond proxy” or “interest defensive” stocks soared. These are stocks that have reasonably predictable and reliable earnings, usually independent of the economic cycle, and offer attractive yields in comparison to cash. These  include the likes of Transurban, Sydney Airport, Medibank, Woolworths, Coles, property trusts such as Dexus and Goodman and utilities such as APA.

BHP, Rio and Fortescue have also performed strongly following a surge in the iron ore price.  The latter hasn’t been on the back of an improving outlook for world growth and steel production, but rather due to a supply disruption to the world’s largest producer (the Brazilian miner Vale) after the collapse of a tailings dam in January.

And then there has been a huge rally in our local tech darlings – WiseTech, Appen, Afterpay, Altium and Xero (the so called WAAAX stocks). As our local market looks to reward growth and prices stocks on multiples of revenue, rather than multiples of earnings, some of these stocks are up by more than 100% in 2019. Our tech sector is now amongst the most expensive in the world, pushed by the relative paucity of local IT companies available to Australian fund managers to invest in.

2019 is proving to be a very strange year!

However, the longer term data shows that many years are “strange” and that “mean reversion” is the norm. This suggests that if one component or sector of the market does really well for a while, it will eventually have a period where it does poorly so that over the longer term, performance will cluster closely (i.e. revert to the mean).

The following table shows the performances of the different components and industry sectors that make up the ASX over the last 1 year, 3 years, 5 years and 10 years. The top 20 stocks, for example, have outperformed over the last 12 months, but underperformed over the last 5 years. As a group, they  did well in the first half of the decade, but not so well in the second half, meaning that the 10 year return (an average of 9.7%) is very close to the overall market’s 10.0% pa. The midcap 50, while having an off year in 18/19, is still the best performing component over 10 years at 11.0% pa.

Australian Sharemarket Total Returns to 30 June 19

Source: S&P Dow Jones

The same story with the industry sectors. With the exception of the energy sector, the returns over 10 years are clustered around 10% pa. There is more variability over the shorter periods, suggesting that mean reversion tends to apply.

It would be wrong to draw the conclusion that mean reversion will necessarily apply to the performances of the small caps and mid-caps.  However, there has been an improvement in the month of July relative to the top 20 stocks, and if the interest rate cuts and other stimulus measures work as the Reserve Bank hopes they will (boosting consumer confidence, consumer spending and in turn economic growth), some of our smaller companies will witness an improvement in trading conditions. If the market expects earnings to improve, share prices should rise.

Standing in the way of this could be Donald Trump and his trade war. But with a lower dollar, fiscal and monetary stimulus measures in place, and other parts of the market starting to look really expensive, a scenario that favours small and mid-cap stocks could be developing.

How can you play small or mid-caps?

It is hard for a private investor to play without a “managed position” due the challenges of building a diversified portfolio. An easy option is to consider index tracking exchange traded funds. Blackrock’s iShares has ISO, an ETF that tracks the Small Ordinaries Index (stocks ranked 101st to 300th by market capitalisation). Betashares has SMLL. There is also an ETF from VanEck which tracks the Midcap 50 index (MVE).

Theoretically, an active manager should be able to do well in this space because  companies are less well analysed and researched, and their buying or selling can have a bigger impact on the price. There is a plethora of managed funds in this area, as well as several listed investment companies. Two that aren’t trading at a significant premium to their NTA (net tangible asset value) are Mirrabooka (MIR) and WAM Microcap (WMI).   

Published: Thursday, August 01, 2019

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