Investing in Australian small companies

Market insights

Monday 02 May 2016

Is now the time to look beyond the big Australian ‘blue chips’?

There is a common theme in capital markets that small cap companies will usually outperform their larger peers and that’s backed up by a number of academic papers. Intrinsically that makes sense, well run small companies are likely to turn into well run large companies and equity investors are naturally attracted to growth stories. However, over the past five years Australian small companies have not conformed to this phenomenon, with the Australian small companies index underperforming its larger counterpart by 28.5% (to 31 March 2016).

We have identified key reasons for the relative underperformance over the last five years and below we explore some current themes affecting the Australian small cap market:

  • Headwinds responsible for small cap underperformance have abated.
  • Australian small companies are well placed to capitalise on an emerging Chinese middle class.
  • Technology means size is no longer a competitive advantage.


Headwinds responsible for small cap underperformance have abated

In the Australian market, specific macroeconomic factors have driven small cap underperformance. This includes the strong performance of financials - predominantly a large cap sector and the underperformance of small cap resources. Looking forward, a normalisation of resource company valuations and a subdued outlook for the big banks provide a much more favourable outlook for the small end of the market.


Australian small companies are well placed to capitalise on an emerging Chinese middle class

For a select group of companies, there is no better place to be right now than Australia. A necessary rebalancing of the World’s second largest economy from investment to consumption is happening right on our doorstep – through the emergence of the Chinese consumer. The Chinese economy will remain an important driver for Australian equity market returns – and an immense opportunity for Australian companies. Like previous demand trends in the Chinese economy, there will be winners and losers as consumption trends flex, regulatory change takes place and the competitive environment evolves. The ability of a small cap active manager to identify companies that will legitimately benefit from this evolving thematic will be a strong driver of returns over the medium term. A high profile example of this is Blackmores, which has seen significant demand for its consumer health products from the Chinese consumer in recent years.


Technology means size is no longer a competitive advantage

The rise of business models enabled by technology means the age of disruption is here – and in this regard, Australia is no island. Australia is a high cost place to do business and the relative size of the Australian market has meant that the tyranny of distance has worked in favour of the incumbents, despite inflated margins on offer. Small innovative companies will take advantage of technology to deliver dynamic growth. The rise of the online market place, software as a service and the ability of technology to provide exponential growth from a low base, especially for small companies, is disrupting traditional business models. An example of this can be seen through Aconex, a leading cloud collaboration platform for the global construction industry, with the potential to rapidly grow scale and market share from 4%, in a US$5.6bn market.


Conclusion

Small cap underperformance over the past five years was a result of specific macroeconomic conditions that favoured the large financial weighting of the ASX200 and disproportionately impacted the resources sector in the Small Ordinaries index. Looking forward, a subdued earnings outlook for the big banks and a normalisation in resource company valuations means investors will be rewarded for looking further down the size spectrum. For an active investor with the skill set to differentiate those companies that will truly benefit from the changing macroeconomic landscape we think now is an exciting time to be investing in Australian small companies

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