The ex-20 investment opportunity

Strategies

Monday 16 March 2015

Diversification and growth beyond the ASX20 Index

Most investors are familiar with the S&P/ASX20 Index. It comprises the 20 largest companies by market capitalisation on the Australian Securities Exchange.

The constituent 20 stocks dominate the market, with the portfolios of many Australian investors heavily weighted with them.

These high-profile, heavily-researched companies seem like a safe investment for financial advisers and their clients, especially in an economic environment in which both inflation and bond yields are low. However, many investors may be missing out on the opportunities offered by 'ex-20' stocks – those outside the top 20.

Specifically, the benefits include the fact that ex-20 companies:

  • may have less research
  • offer diversification benefits across industries
  • may be less mature businesses and have potential for higher growth.

Under-researched stocks

Some ex-20 companies have less research by investment analysts than those in the ASX20. Investors who undertake detailed, risk-focused research can therefore uncover opportunities in the space.

A selection of ex-20 companies may also be leaders in their specific industry categories, which means they can offer the stability and earnings predictability of those in the ASX20 along with enhanced opportunities for above-market returns.

Sector diversification

The ASX20 Index is heavily concentrated on just a few industries. For example, financial services companies account for more than 50 per cent of the index's stocks. Meanwhile, a number of sectors such as industrials, property and healthcare have a low representation.

This means investors who focus on the top 20 may fail to achieve a satisfactory level of sector diversification in their portfolios.

Stocks outside the ASX20 represent a broader, more even spread of industries. So ex-20 stocks can, paradoxically, help investors minimise risk and protect capital.

Growth opportunities

Most ASX20 companies are mature businesses that may pay higher levels of dividends, but have fewer organic growth opportunities. While these companies may be suitable for income-seeking investors, long-term wealth accumulators should also seek out quality higher growth companies.

The 'chase for yield' trade has benefited ASX20 companies in recent years, but this is unlikely to be sustained indefinitely. Globally, bond yields are at decade lows – should they normalise over the long-term, the yield trade would also unwind.

Case study

An example of the opportunities that exist with ex-20 stocks can be seen in a comparison of two upstream energy companies – one in the ASX20 and the other outside.

The ASX20 company may be bigger in terms of market capitalisation - however, it's also mature and some analysts may argue it is facing potential production decline, at least in the short term.

The company outside the ASX20, on the other hand, has numerous organic options to grow production.

A widely-held belief is that the ASX20 company has become a 'yield play' in the short term, as it has increased its dividend payout ratio to compensate investors for lack of growth. Meanwhile, the other company's forecast production growth is likely to drive superior earnings growth.

It's a comparison that suggests how investors who focus solely on the ASX20 may be missing out on significant and relatively secure growth opportunities.

Macquarie's ex-20 strategy

Macquarie Private Portfolio Management (MPPM) manages a quality-focused ex-20 portfolio built on a robust, proven investment process.

Its objective is to outperform the S&P/ASX300 Accumulation Index, excluding ASX20 stocks, by 3 per cent (pre-fees) over a rolling five-year period, with a focus on capital appreciation and delivered in a tax-effective manner.

The strategy favours high-quality, mid-capitalisation companies that have a sustainable competitive advantage within an attractive industry.

Each of the companies selected is identified as having a strong management team, a solid balance sheet and a clear strategy based around a superior product/service offering. An attractive industry is identified as one with high barriers to entry and pricing power over its customers.

Ideally, these companies reinvest profits back into their business to reinforce their competitive advantage over the long term.

The ex-20 portfolio is worth the consideration of investors such as individuals and SMSFs who are focused on long-term wealth accumulation.

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This information is provided by Macquarie Private Portfolio Management Limited ABN 26 089 987 388 AFSL 237506 (MPPM).  Unless stated otherwise, any other information has been prepared by Macquarie Bank Limited ABN 46 008 583 542 AFSL and Australian Credit Licence 237502.

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