PERFORMANCE OF AUSTRALIAN SMALL CAPS

Transcription

1 PERFORMANCE OF AUSTRALIAN SMALL CAPS CFS Wholesale Small Companies Core discussion paper June 215 Introduction We analysed the Australian equity market over the past 15 years to ch 215. Over this time period, the S&P/ASX 1 Accumulation Index returned 9.1% pa, versus a return of 4.3% pa from the S&P/ASX Small Ordinaries Accumulation Index. Since mid-212, the S&P/ASX 1 Accumulation Index, which represents the 1 largest companies listed on the Australian Securities Exchange (ASX), has risen a remarkable 63.3% as the current bull market has charged ahead. Over the same period, the S&P/ASX Small Ordinaries Accumulation Index, which tracks the performance of the ASX s small-cap companies (outside the top 1), has increased just 14.%. The contrast between the two indices is stark and particularly incongruous when you compare the two indices over the preceding three years or so. Between ch 29 and June 212, the S&P/ASX Small Ordinaries Accumulation Index outperformed the S&P/ASX 1 Accumulation Index by 8.1%. Active management in Australian small caps has added significant value for investors over the same 15 year period. The median active small cap manager outperformed the S&P/ASX Small Ordinaries Accumulation Index by 7.% pa during this time. We believe this is due to the inefficiency of the small cap market, especially when compared to the large cap S&P/ASX 1 Accumulation Index. Over the same 15 year period, the median active large cap manager only outperformed the S&P/ASX 1 Accumulation Index by 2.1%. This discussion paper seeks to address a number of points: The performance of the S&P/ASX Small Ordinaries Accumulation Index relative to the S&P/ASX 1 Accumulation Index and why there seems to be no small cap premium present in the Australian market; How the small resources sub-sector has dominated small cap returns over time; and How active small cap managers have performed over the past 15 years and the type of environments where they have struggled to outperform. ket performance Over the past 15 years, Australia is one of the few markets in the world that has not exhibited a small cap equity outperformance versus large caps (chart 1). In aggregate, Australian small caps have underperformed large caps by 4.9% pa. CHART 1: CUMULATIVE PERFORMANCE OF THE S&P/ASX SMALL ORDINARIES ACCUMULATION INDEX VERSUS THE S&P/ASX 1 ACCUMULATION INDEX S&P/ASX Small Ordinaries Accumulation Index S&P/ASX 1 Accumulation Index Adviser use only

2 Caution is needed when analysing small cap index performance, especially when compared to global small cap indices, given the changes in underlying sector composition and the impact market thematics can have on small cap index returns. For example in the early 2s the S&P/ASX Small Ordinaries Accumulation Index was influenced by technology stocks, which reached their peak during the dotcom boom followed by a significant fall. By ember 21, the rally in Australia s resources sector meant that mining or mining services companies accounted for nearly half of the market capitalisation of the S&P/ASX Small Ordinaries Accumulation Index. As at 3 April 215, this figure had dropped to 16% (chart 2) as the small resources sub-sector struggled against a background of weaker commodity prices and an uncertain demand outlook from China. CHART 2: BREAKDOWN OF THE S&P/ASX SMALL ORDINARIES ACCUMULATION INDEX INTO SMALL INDUSTRIAL AND SMALL RESOURCES STOCKS 1% 9% 8% 7% 6% 5% 4% 3% 2% 1% % Industrials Resources Indeed returns from the S&P/ASX Small Ordinaries Accumulation Index have been influenced by the boom-bust cycle of mining and mining-related companies. As chart 3 shows, the small resources sub-sector has been volatile, particularly compared to the more stable small industrial sub-sector. The performance of small resources stocks is clearly significantly influenced by the boom-bust cycles that are typical of commodity prices and demand from emerging regions. For example, strongly rising Chinese demand for commodities resulted in strong share price performance for Australian miners and mining-related companies during the mid-2s. CHART 3: CUMULATIVE PERFORMANCE OF THE SMALL RESOURCES AND SMALL INDUSTRIAL SUB-SECTORS OF THE S&P/ASX SMALL ORDINARIES ACCUMULATION INDEX 1, 9 8 S&P/ASX Small Resources Accumulation Index S&P/ASX 1 Industrials Accumulation Index

3 Performance of active small cap managers Given that passive small caps have underperformed the large cap index over the past 15 years, it is important to consider the extent to which active small cap managers have added value. Over the 15 year period, the median active small cap manager delivered better than index returns (chart 4). Importantly, not only did active management result in a return that was better than the S&P/ASX Small Ordinaries Index, but the absolute level of return achieved (11.3% pa) was also greater than that realised for the large cap S&P/ASX 1 Accumulation Index (9.1% pa). CHART 4: CUMULATIVE PERFORMANCE OF THE MEDIAN SMALL CAP MANAGER VERSUS LARGE CAP AND SMALL CAP S&P/ASX INDICES 6 5 S&P/ASX Small Ordinaries Accumulation Index S&P/ASX 1 Accumulation Index Median Active Small Cap Manager Source: Factset, Mercer, CFSGAM. Analysing the rolling 1 year returns, we can also observe that the outperformance of the median active small cap manager is reasonably persistent across market cycles. One exception to this persistency was the period 24 to 28, where a sharp increase in the value of small resources stocks saw the median active small cap manager struggle relative to the index (chart 5). CHART 5: ROLLING 1 YEAR ACTIVE RETURN MEDIAN ACTIVE SMALL CAP MANAGER VERSUS THE S&P/ASX SMALL ORDINARIES ACCUMULATION INDEX Excess Return versus Index % Source: Mercer, CFSGAM. A closer look at the performance of active managers in The period from 24 to 28 was an unusual time in the local equity market, with Australia in the midst of a Chinese demanddriven commodity boom. During this period, prices of bulk commodities such as iron ore and coal and LME 1 traded metals such as copper and nickel were well above the marginal cost of production (chart 6). New and predominately high cost producers could make very healthy margins/profits in this environment. 1 London Metal Exchange.

4 CHART 6: RESERVE BANK OF AUSTRALIA INDEX OF COMMODITY PRICES; NON-RURAL COMPONENT 4 35 RBA Index of commodity prices; Non-rural component; A$ 3 $A Source: RBA, CFSGAM. This commodity price appreciation was driven by significant supply shortages in iron ore, coking coal and, to a lesser extent, steaming coal. Ongoing strong Chinese demand meant that higher prices were sustained in that segment of the commodity market. Trading in LME traded commodities was also influenced by Chinese demand as well as, to a smaller extent, financial buyers diversifying into hard commodities. Companies with existing projects which were currently producing, near production or about to be funded came into investors focus and resulted in significant share price appreciation in a number of small resources stocks over the period. Merger and acquisition activity also featured as a share price driver with corporates and offshore investors making bids for small resources stocks. With hindsight, the investment merits of high cost, short mine life small resources companies did not stack up using traditional investment metrics. Typical quality and valuation measures were largely ignored by investors looking to profit from the boom. It was these sorts of stocks that many active managers avoided holding as they were clearly at the speculative end of the investment universe. The end result was that most active managers struggled to keep pace with the broader S&P/ASX Small Ordinaries Index during this period. Towards the end of this boom period, there were signs that all-time high commodity prices were not sustainable. Although costs had risen significantly in the industry due to labour and the mining of high cost ore bodies it became clear that commodity prices were unsustainably high without a significant reduction in supply. This left the share prices of many of the more speculative resource companies vulnerable to a correction and this subsequently occurred. The market s focus on resources prior to 28 resulted in a number of industrial companies with proven management, good industry positions, strong cash flow and solid balance sheets being overlooked by investors. The small industrials sub-sector underperformed the small resources sub-sector during this period (chart 7). As a result the market had mis-priced a number of these companies, providing investment opportunities for patient active small cap investors. Looking back to chart 5, we can see that the performance of the median active small cap manager improved following the period as they had avoided these expensive resource companies. CHART 7: SMALL RESOURCES VERSUS SMALL INDUSTRIALS ROLLING 1 YEAR PERFORMANCE 8% 6% Small Industrials Underperform 4% 1 year return 2% % -2% -4% -6% Small Resources Underperform -8%

5 More recently the well-documented end of Australia s recent resources investment boom has hit the mining and mining services sector hard. As China adapts to a more modest pace of economic growth, actual Australian resource export volumes remain close to all-time highs, particularly in bulk commodities. However spot commodity prices have fallen, in some cases significantly, due to new supply coming on line and a less bullish future demand outlook. In addition, many of the resources-related expansion projects announced in the mid-2s are coming to an end, leaving mining service companies with a subdued outlook, shrinking order books and pressure to cut costs. Chart 7 visually highlights the extent by which small mining and mining services companies have underperformed in recent years. This has particularly been the case in the more speculative end of the resources investment universe. Since ember 21 the small resources or mining segment has declined by more than 7%. By contrast, small industrial stocks have performed relatively well, increasing by more than 4% over the same period. Given the popularity of small industrial stocks among active small cap managers, it is unsurprising that the median active small cap manager has significantly outperformed the S&P/ASX Small Ordinaries Accumulation Index since ember 21; in fact by nearly 44%. How are active small cap managers able to generate such high and persistent alpha? All of the above analysis underlines the structural inefficiency of the Australian small cap market, which allows active and wellresourced managers to outperform the Index so significantly. We believe there are a number of factors behind the structural inefficiency of the market: Sell side analyst coverage: The average large cap stock has between 13 and 16 analysts providing research coverage. A much lower number of analysts typically cover small caps, providing an opportunity for well-resourced managers to identify mis-priced opportunities (chart 8). CHART 8: AVERAGE NUMBER OF ANALYSTS COVERING S&P/ASX 3 CONSTITUENTS # of brokers covering to 1 1 to 2 2 to 3 3 to 4 4 to 5 5 to 6 6 to 7 7 to 8 8 to 9 9 to 1 1 to to to to to to to to to to 2 2 to to to to to to to to to to 3 Source: GS&PA Research, I/B/E/S, as at ch 215. Rank of company within ASX 3 Return dispersion: The divergence of returns in the small cap sector presents alpha generation opportunities for active managers able to identify outperformers as well as underperformers. Avoiding the losers is just as important as identifying the winners in a market as divergent as this (chart 9). Preserving capital is a key focus.

6 CHART 9: RETURN DISPERSION OF S&P/ASX SMALL ORDINARIES INDEX CONSTITUENTS 5 Rolling 12 months share price performance (%) m to 31 ch 215. This return profile is reasonably consistent over investment market cycles. The spread between the worst and best performers has remained very wide over the past 1 years, as Chart 1 shows. Even in the depths of the Global Financial Crisis in 28, there were still opportunities for small cap investors to generate positive returns. This is where the investment opportunity lies for investors in the small cap universe. CHART 1: DISPERSION OF S&P/ASX RETURNS 3 25 ASX 1 Small Ordinaries Dispersion gap between the highest and lowest performing stocks Return difference % pa Greater opportunity set Source: [Factset]. Benchmark composition: The structure of the small cap benchmark is less concentrated than the large cap S&P/ASX 1 Index, with the largest 1 constituent s only accounting for around 15% of the index (table 1). TABLE 1: INDEX CONCENTRATION COMPARISON OF LARGE AND SMALL CAP INDICES S&P/ASX Small Ordinaries Weight Sector S&P/ASX 1 Index Weight Sector Domino's Pizza 2.1% Consumer discretionary Commonwealth Bank 9.8% Financials Liquefied Natural Gas 1.7% Energy Westpac Banking 7.7% Financials M2 Group 1.6% Telecom services BHP Billiton 7.6% Materials Slater & Gordon 1.6% Consumer discretionary ANZ Banking Group 6.7% Financials Veda Group 1.6% Industrials National Australia Bank 6.2% Financials Qube Holdings 1.6% Industrials Telstra Corporation 5.5% Telecom services Spotless Group Holdings 1.5% Industrials Wesfarmers 3.6% Consumer staples NIB Holdings 1.4% Financials CSL 3.1% Health care Platinum Asset Management 1.3% Financials Woolworths 2.6% Consumer staples Fletcher Building 1.3% Materials Rio Tinto 1.8% Materials Total weight in S&P/ASX Small Ordinaries Source: [FactSet]. 15.7% Total weight in S&P/ASX % In addition the S&P/ASX Small Ordinaries Index has much greater sector diversification than the large cap S&P/ASX 1 Index (chart 11).

7 CHART 11: SECTOR DIVERSIFICATION OF THE S&P/ASX 1 INDEX AND S&P/ASX SMALL ORDINARIES INDEX S&P/ASX 1 S&P/ASX Small Ordinaries 2.6% Consumer discretionary 6.6% Industrials 14.5% Materials 6.7% Property trusts 6.% Health care 43.9% Financials ex property trusts.6% Information technology 4.3% Energy 5.7% Telecommunication services 7.1% Consumer staples 2.1% Utilities 24.8% Consumer discretionary 15.7% Industrials 13.6% Materials 1.2% Property trusts 8.5% Health care 8.4% Financials ex property trusts 5.2% Information technology 5.% Energy 4.9% Telecommunication services 3.% Consumer staples.7% Utilities Source: [FactSet]. This diversity provides active investors with plenty of opportunities to generate alpha while avoiding the lower quality, more speculative small cap stocks. It is important to remember that investing in a small companies fund is very different from investing in the small companies index. A good small companies fund should be invested in a concentrated group of stocks, which collectively have a better return profile than the Index. In aggregate, a good small companies fund is also likely to have a stronger balance sheet, significantly better management, more free cash flow and a higher ROE than the index average. Index valuations: caution when using PE ratios in Australian small caps When looking to value Australian small companies, a large amount of research refers to the PE of the universe, often relative to its historic average and relative to the large cap S&P/ASX 1 Index. The research typically leads to conclusions suggesting the market is either cheap or expensive, perhaps in order to provide some guidance to asset allocators. There is certainly some correlation between the PE of the small companies universe and the value of the sector, but it is important to be aware of the pitfalls of relying on rudimentary statistics to make asset allocation decisions. With respect to valuation, the ideal small companies portfolio will offer significant value relative to the Index. We use the term value rather than cheap because optically the fund might not look very cheap at all. The average PE of an actively managed fund might, for example, be higher than the Index. A good example of value versus cheap is the period post 211, with most of the seemingly cheap mining services stocks buckling under revenue and margin pressure from their key customers. High cost miners in the gold and iron ore sectors, for example, suffered from declining commodity prices and the strength of the Australian dollar. While the currency pressures have now receded somewhat, there has been further weakness in commodity prices. Active management of small caps has been successful over time because the financial models typically used to better understand a company s fundamental business value are based on Discounted Cash Flow and a range of other valuation metrics. Active managers tend to not be unduly concerned with other measures, such as PE or price to book ratios, which can be misleading and distorted by accounting practices. Instead, the focus is on the free cash flow generation of a business and, most importantly, the sustainability of that free cash flow. Typically when investing in small companies, which tend to be emerging/growing businesses, the company s growth profile over the next three years can be a better indicator of its value than a PE ratio. The PE ratio can often underestimate a company s actual growth potential and understanding a company s growth trajectory can enable active investors to generate consistent value. Want more information? For more information on the Colonial First State Wholesale Small Companies Core Fund, please contact your local Business Development Manager, Adviser Services on (8am to 7pm AEST) or visit colonialfirststate.com.au/investments/ This document has been prepared by Colonial First State Investments Limited ABN , AFS Licence (Colonial First State) based on its understanding of current regulatory requirements and laws as at 15 June 215. While all care has been taken in the preparation of this document (using sources believed to be reliable and accurate), to the maximum extent permitted by law, no person including Colonial First State or any other member of the Commonwealth Bank of Australia group of companies, accepts responsibility for any loss suffered by any person arising from reliance on this information. Colonial First State issues interests in managed investment funds including those made available under FirstChoice Investments and FirstChoice Wholesale Investments. 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