This article is written by Boyd Peters. He manages Investor Services and Shareholder communications for listed investment company Contango MicroCap Limited (ASX: CTN). This article is for information purposes only.
For the first time since 2011 the small and microcap sector is poised outperform large cap indices. If earnings season delivers results "in-line with expectations" the small part of the market may perform strongly.
The last few years have been difficult for small companies with the Small and Emerging Companies Index ("Microcap") under-performing large cap indices.
Chart 1 shows the differential in the rolling 12 month performance between the Large and Microcap sectors between 2005 and early 2013.
Periods where red was above the line were times where microcaps outperformed large caps, and vice versa. The chart does not indicate positive or negative returns- purely differential. We see who was the "faster horse in the race".
Chart 1: Source: Contango MicroCap Limited
In early 2013 small cap valuations were compelling, as shown in Table 1 below. Many cyclical investors observed the extreme performance disparity between large and small indices and rotated into these stocks.
| FY14 Valuations(as at 25.02.13) | S&P/ ASX 100 | Small Ordinaries |
| Price/ Earnings | 13.6x | 10.5x |
| EPS growth | 12.4% | 24.7% |
| Dividend Yield | 4.7% | 3.8% |
| Return on Equity | 14.3% | 12.0% |
Table 1: As at 25.02.2013
Source: Contango Asset Management Limited
Table 2 shows that investors in small and micros enjoyed positive returns, in line with the valuations inferred 12 months earlier.
| 12 month return | |
| ASX Small Ords Accum Index | 13.1% |
| S&P/ASX Emerging Co's Accum Index | 14.7% |
Table 2: As at 30.06.2014
Source: Contango Asset Management Limited
However, investing is also a relative game meaning that investors should know how this performance compared to the large cap sector.
Those investors who in early 2013 rotated into smalls on the back of lower P/Es and higher earnings growth would have done well to understand the role relative valuations and momentum play.
To observe how this expressed itself we extend Chart 1 forward to August 2014.
Chart 2: Source: Contango MicroCap Limited
Chart 2 shows that notwithstanding the compelling fundamentals and subsequent returns from the small and microcap sector, the relative underperformance to large caps grew further, peaking at a -52.6% on 30 April 2013.
Is now the time?
Investors may ponder if now is the time to rebalance into smaller companies in the belief that they will now outperform large caps.
Chart 3 looks at the actual performance of the large and microcap indexes from which the differential was extrapolated. For the first time since 2011 microcaps are generating a positive 12-month rolling return and nearly outperforming their large cap counterparts.
Chart 3: Source: Contango MicroCap Limited
For the first time since 2011 the Micro's Index is delivering positive rolling annual returns. Table 3 shows the one-year forward valuations across the sectors. The general consensus as we enter earnings season is that valuations were "reasonable".
| FY14 Valuations(as at 07.08.143) | S&P/ ASX 100 | Small Ordinaries | CTN ["Micros"] | |
| PE (x) | 14.9 | 15.5 | 12.6 | |
| EPS growth (%) | 4.8 | 25.4 | 36.6 | |
| Yield (%) | 4.7 | 3.8 | 3.6 | |
| Return on Equity (%) | 16.1 | 13.5 | 16.2 |
Table 2: As at 07.08.2014. Source: Contango Asset Management Limited
To sustain and then extend the positive returns the market requires the current valuations (fundamentals) in smalls and micros to meet expectations.
All eyes on this earnings season
August 2014 shapes as a significant period for the microcap sector as investors are poring over results to see if valuations are being confirmed. Positive or even in-line outcomes could see a bounce in small and microcap stocks.
Looking to FY15, microcap fund manager Contango MicroCap Limited anticipates solid growth as the economy transitions from mining investment to non-mining investment and consumption. In this environment, it prefers companies that have solid growth profiles and high free cash flow yields while avoiding low growth defensives and pure yield companies, seeing select opportunities within the microcap space.
Some of the larger positions in the CTN investment portfolio include Cedar Woods Properties Limited (ASX: CWP), Villa World FPO (ASX: VLW), Village Roadshow Ltd (ASX: VRL), iProperty Group Ltd (ASX: IPP), Mayne Pharma Group Ltd (ASX: MYX) and Prime Media Group Limited (ASX: PRT).
The small cap sector typically outperforms large caps when risk appetite is strong. Whilst that might not describe the current environment, investors can find select opportunities within the small cap space. That is particularly the case for well managed, small industrial companies with strong EPS growth prospects and solid balance sheets.
In most cases investors can remain cautious about small companies exposed to the mining sector, particularly if they are early-stage or carrying high debt levels. In a stronger growth environment, when bond yields and commodity prices are typically rising, investors can look to increase exposure to mining stocks. As with large cap investing, investors can look for the right combination of high quality and attractive valuation at the right point in the business cycle.
Note: In Table 2 listed microcap CTN's investment portfolio is used as a proxy for the fundamentals of the microcap sector as the weights of the stocks within the S&P/ASX Emerging Companies Accumulation Index are not known.
