Dig deeper when you invest in small cap stocks

The information in this article is market commentary only and reflects Lincoln's views and beliefs at the time of preparation, which are subject to change without notice. To obtain up-to-date information, please contact us.

If you were an investor in traditional businesses such as the banks, Telstra or AMP over the past year, you may be wondering what all the fuss has been about regarding the market.

With the All Ordinaries currently over 6200, we are now only 10% from our all-time high set over a decade ago on 1 November 2007. Disappointingly the share prices for many of the stocks mentioned above, particularly the latter two, are languishing well below prices exhibited at the previous market peak. This is leaving investors frustrated and disappointed.

Business specific issues aside, the tale of mediocre performance is also a reflection of the lack of dynamic and sustainable growth that these large cap, household names have achieved in recent years. This dichotomy is no better reflected than in an analysis of the S&P/ASX50 (XFL) versus the S&P/ASX Small Ordinaries (XSO). It shows strong divergence over the past three years, with the latter returning over 34% while the XFL returned less than 4.5%.

Source: Lincoln Indicators, Bloomberg

This set many proactive investors on a path of exploration, digging deeper into the market beyond the bell-weathers to find diamonds in the rough offering more enticing growth metrics and more marketable investment stories. In turn, this led to a sustained growth cycle over the past few years, except for a short blip in late 2016-early 2017.

The market has been operating in a ‘risk-on’ mode as it attempts to find the future leaders of tomorrow. As the graph below highlights, investors have been willing to pay a premium for quality opportunities. To date these companies have not only met expectations but exceeded them. Despite previous spikes, the PE for the XSO reverts to normal levels while earnings catch up to previously held lofty price expectations; , sustaining the growth cycle.

Source: Lincoln Indicators, Bloomberg

As we delve deeper into the market the risks elevate. In fact, entering the small cap market blindly is risky. Particularly as many smaller companies are yet to establish themselves as proven business models able to generate sufficient cash flows to uphold their operations. A diagnostic of the market excluding the constituents of the ASX200 who tend to be larger businesses, shows us that 80.8% of all remaining companies on the ASX are exposed to unacceptable levels of financial risk, according to Lincoln Indicators proprietary Financial Health Methodology. This is a reminder of the minefield surrounding small cap investing.

Emphasising this point is the performance of such businesses. Growth cycles in the market typically see risk appetites increase. Therefore, one would expect unhealthy businesses to do well in terms of performance as investors ignore the current fundamental weaknesses in the hope of what may come. But for the past year the median average return for unhealthy businesses has been a very disappointing -2.99%. Whereas financially healthy businesses have returned a median average of 13.37%. For small cap investors this becomes more powerful as excluding the behemoths of the ASX50 improves median performance to 16.7% for the past 12 months.

At Lincoln, it is our long-held view that investors who are looking to capitalise on the current growth cycle by investing in smaller cap companies are best served by focusing on healthy businesses. This view is supported by the evidence that it significantly enhances the chance of picking a winner that can deliver sustainable returns, reducing the risk of portfolio implosion when the current investment cycle eventually changes. We don’t know when that day will come, but it will arrive.

*All figures as at 15 June 2018

Published Tuesday, 26 June 2018
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