Look to smaller companies for higher returns and genuine diversification – but beware the risks.

It is commonly assumed that if you want a higher return you need to take on more risk. But consider the following table. 

Source: S&P Indices at 29 November 2019. *Volatility is based on the standard deviation of monthly returns. 

Over the past 10 years, returns have actually been inversely correlated with risk, as measured here by volatility . 
The table shows: 

• Investors can have their cake and eat it too over those 10 years. Mid-caps delivered the highest returns with the lowest volatility, better even than large- caps.
• You do not always get paid for taking on more risk. The Small Ordinaries and, even worse, the Emerging Companies index, materially underperformed and did so with higher volatility. 

(Editor’s note: Do not read the following ideas as stock recommendations. Do further research of your own or talk to a licensed financial adviser before acting on themes in this story). 

What gives?

In our view, these results can be explained by the overall quality of the underlying stocks.

Quality can be thought of as the strength of a company’s competitive position, management, corporate governance and balance sheet. Fundamentally, these are the attributes that govern both the risks and rewards of owning stocks. On both counts investors are better off with higher quality.

The ‘sweet spot’

Most investors assume they need to compromise on quality if they choose to invest beyond the large-caps. However, mid-caps are a sweet spot on ASX where there is still the quality but also more potential upside from generally better growth prospects.

There are other benefits as you move further down the market:

• Many investors lose comfort beyond the blue chips where they feel safe, and the perceived riskiness of the lesser-known small and mid-caps get priced in. 
• There is less media, broker coverage and competing investor attention. This means there is greater reward for investors’ own proprietary research, skill and effort. 
• Investors can get more direct leverage to a particular investment trend or theme. Woolworths is essentially a play on general retail, but you can alternatively invest in category winners such as JB Hi-Fi, Lovisa and Baby Bunting. 
• There are typically more takeovers and IPOs that can spruce up returns.

What about small-caps? 

It is really only when you move down deeper into smaller-cap stocks that quality starts to become an issue. 

Small-caps, including micro-caps, represent a very diverse range of stocks: the good, the bad and the ugly, in roughly equal measures.

In aggregate they underperform over time; but it is also where you will find some of the best opportunities. 

Taking a selective approach means you can do wonderfully well, as seen in the Bennelong Emerging Companies Fund (mFund: BAE05). 

The opportunity

Small-caps can offer spectacular growth – particularly given their less mature businesses – and this can supercharge returns.

This was on show in 2019 in a remarkable willingness on the part of investors to pay up for growth, most clearly seen among fintechs, biotechs and other tech names offering disruptive growth.

Source: Company reports, IRESS at 29 November 2019.

The risk

In large part because of stocks like these, the Emerging Companies index returned approximately 34 per cent over the past year. 

However, we know this group of emerging companies underperforms over time and their volatility means higher highs and lower lows. To this end, smaller-cap stocks are particularly sensitive to investor sentiment and investment flows. 

This is most pronounced in whatever is “hot”’ at the time – shale oil, 3D printers, lithium or tech. Hype builds, valuations stretch and stock prices can overshoot. We saw signs of this in late 2019, with Nearmap, Jumbo and Pro Medicus all falling a third from their highs, albeit with still stellar returns for the year. 

It is a lesson for investors to be wary of the hype.

How to sort the wheat from the chaff?

Again, it all comes down to quality – in our experience the least risky and most reliable guide to accessing the outsized returns available. 

small-cap investing is as much about what to avoid as what to own. After all, more than 60 per cent of all small caps delivered a negative return over the past 10 years, leaving less than 40 per cent from which to make money.

Genuine diversification

An important benefit of small and mid-caps is the diversification they offer. 

Many large caps represent much the same thing. For example, 11 of the top 20 stocks are mature, domestic-only oligopolies, with limited growth in Bennelong’s view but large dividend payout ratios . Think Commonwealth Bank, Woolworths and Telstra. 

In contrast, smaller caps offer far greater diversity of investment propositions and this allows more genuine opportunity to diversify. This includes: 

• Business model
• Industry
• Stage-of-lifecycle
• Entrepreneurship
• Idiosyncratic growth strategies
• Cyclicality
• Geographic exposure

At present, Bennelong sees more interesting opportunities in global companies than the largely domestically focused top 20. Particularly interesting are those profitably leveraging an “exportable” competitive advantage such as a brand or intellectual property into far greater growth potential offshore. 

Examples include Treasury Wine (which owns the Penfolds brand), Aristocrat (video and slot games), Breville (new appliance designs) and IDP (with its dominant IELTS English-testing business).

Attractive valuations

Smaller stocks have historically traded at a premium to large caps because of their stronger growth prospects. Today this premium is as small as it has been for decades, even though these stocks continue to offer far superior growth. 

From the earlier table, mid-caps are trading on a PE multiple of 17 times, on a par with large-caps, while small-caps are just half a PE point higher. 

Given relative valuations between the two historically mean revert, the implication is that small and mid-caps should outperform large caps from here.

That said, it is wise to consider the key message of this article: it pays to be particularly selective, especially with small caps. 

To that end we would recommend a focus on quality and to watch out for any hype.