Small Caps, Big Promises, Large Risks

This story features PERSEUS MINING LIMITED, and other companies. For more info SHARE ANALYSIS: PRU

By Rudi Filapek-Vandyck, Editor FNArena

I have oft used Perseus Mining ((PRU)) as one prime example in the past, but I nevertheless have decided this once high-flying gold miner remains an excellent benchmark to illustrate what investing in the share market is all about.

Until the second quarter of 2007 one could have snatched up the shares for 50c, or less, but within a few months the ASX board read $1.50. Add: lots of excitement in chat rooms across the country. By late 2008 the price had sunk below 30c.

No problemo, because it wasn't long before the share price embarked on a wild and joyous journey that didn't end until the $4 mark was briefly touched. By then the calendar read September 2009. Things pretty much went downhill and have continued to go downhill since.

As we stare into 2014, the share price is now below 30c, again.

Perseus' example shows what many investors have learned the hard way in years past: smaller mining stocks are not for the inexperienced or for passive investors. For today's exercise, however, I'd like to extend the insights gathered by the Perseus experience to remind everyone that smaller companies in general come with higher risks, more room for disappointment and with less guarantees that the old adage "time in the market" will actually pay off.

Indeed, share markets globally have turned themselves into the best performing asset class this calendar year, but in Australia small and micro caps (it's not always clear where one category starts and the other one ends) have thus far seriously underperformed.

The ASX20 has advanced some 17% this year (add dividends on top), but the Small Ordinaries is still in the red, regardless of dividends, while the S&P/ASX Emerging Companies index is down double digits since the start of the year.

It wouldn't be too difficult to replace Perseus with names out of the industrials space to reveal a similar set of numbers. However, if the share market is to continue its upward path (and just about everyone thinks it will) then money flowing in will eventually trickle down from the Top20 into the smaller cap space. The fact that smaller stocks have been left so far behind this year will only motivate the spruikers and the punters even more.

A few weeks ago I called in during a media presentation by small caps investment specialists NovaPort Capital (www.novaportcapital.com) which I thought contained various remarkable and interesting pieces of research about investing in small caps that I am sharing with you today.

First up, the principals at NovaPort don't believe in indices or in averages. Their motto "there's no such thing as an average company or an average investment outcome" is perfectly illustrated by the first graphic below. It shows calculated returns from small cap stocks in the Australian share market over the last decade.

It remains remarkable how many results cluster together on the left hand side, which is indicative of (strong) negative returns. The next cluster is located at the very opposite of the spectrum. That's where dreams are born and a few fortunes are made.

The "average" between these two outcomes would take us somewhere to the middle of the graph, but that's were the least number of calculated returns are! One statistic derived from NovaPort's research sums it all up: 40% of all small cap stocks in the share market will end up generating a negative return over ten years.

NovaPort's own investment approach dictates that small companies need to generate at least a return of 50% over three years, otherwise they are deemed not worth taking the risk. While that seems like a high investment hurdle, it translates into 16.66% per annum – not even twice the average long term market return.

The underlying message here is: don't jump on small caps if you only think you'll make a few percent here or there. It's not worth the risk. There has to be substantial potential.

One interesting statistic that came from NovaPort's research is that only 20% of small cap stocks achieve the minimum 50% in return over three years. NovaPort's managed funds own some of these stocks. Think retailer Kathmandu ((KMD)), entertainer Village Roadshow ((VRL)) and mortgage broker Austbrokers ((AUB)).

Maybe what investors should remember from all this is that it is twice more likely they might pick a lousy (negative) performer than they might pick a winner worth the risk. Since 80% of all small caps fails to achieve the fund manager's minimum hurdle, there is an argument to be made that the true ratio is more like 4-against-1; it is four times more likely a small cap investment will not reward investors for taking the risk.

This is probably an opportune moment to point out that a lot of these statistics are heavily dependent on starting points and time lines. Take one of the star performers in the share market this year, Fortescue Metals ((FMG)), as an example. Since the trough for resources in July, the stock has more than doubled in price. However, had I bought and held any shares in late 2011 (two years ago) I would still be in the red today.

(My apologies if you think Fortescue is not a small cap story anymore. I am simply picking easy examples to illustrate the point. Mount Gibson generates similar numbers).

As said above: the fact that small caps have been left so far behind this year probably skews the statistics for the three years ahead towards a more favourable outcome this time around, but it won't fully erase the risks involved. This is particularly the case since the weaker and more vulnerable companies have underperformed against their small cap peers, and for a very good reason.

Which is why the following graph should be on everybody's radar (it certainly will feature in my presentation slides next year).

Investing strategies for equities can be roughly split between top-down-ers and bottom-up-ers. The first group builds a macro-view and then drills down towards the best individual stocks in line with this view. The second group simply tries to find excellent opportunities at a cheap price, regardless of any macro-considerations.

Both strategies have their proponents and their critics, and both have merits. Which is exactly what the graph below shows. A quick explanation: the grey bars show the median return for a sector and the orange bar shows the proportion of companies in that sector that have achieved the 50% minimum return hurdle.

Non-surprisingly, pharma, transport, consumer services and telcos and tech -the four sectors with the highest median returns- have also generated the most stocks returning at least 50%. In sectors like media, materials, food and beverages, software and energy the odds have been pretty much stacked against the average investor.

This second NovaPort graph shows that it is far easier to pick winners in a buoyant sector than it is in a sector that is not performing well, but, points out NovaPort, a good company in a bad performing sector is still more likely to perform better than a bad company in a good performing sector.

I think we can all come up with examples to back up that statement. My personal contribution is that I still think that an average performing company in a well-supported sector is more likely to outperform the champions on the rough side of town and even if that is not the case, it is a far easier task to pick the mediocre performer in a good sector than the champ in Losersville.

Yes, I am showing my bias towards top down strategies. I think the second graph above shows how to generate the best returns on a risk-adjusted basis. You pick the market segments that have the wind in the sails and you make sure you avoid the duds. It takes a whole lot of time, talent and experience to weed out the champions from the rest in an underperforming sector, not to mention the risk when making the wrong choice.

This is why I have consistently been warning against investing in gold miners or in mining services providers. If the overall trend is down, associated risk explodes to the upside and you better reveal yourself as being a very talented stock picker, or else.

Just to top off this week's theme, below are 12 month performances by healthcare stocks (thanks to the team at Morgans). The left hand side is why the share market will always retain a natural attraction to people looking to make a buck. The right hand side shows in hard cold outcomes that "risk" is not just a four letter concept.

(This story was written on Monday, December 2nd, 2013. It was published in the form of an email to paying subscribers on that day).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July this year forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

My previous eBooklet (see below) is also still included.

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January this year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

This eBooklet was released in January this year and is included in FNArena's free bonus package for a paid subscription (excluding one month subscription).

If you haven't received your copy as yet, send an email to info@fnarena.com

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