Sizing up the smalls

Generalising is a dark art. The moment one observes an apparent pattern, idiosyncratic data jumps out. Judging small-cap managers falls into this trap.

Firstly, to the organisation. Those that are entirely dedicated to this sector can do well, yet are interspersed are some big shops with banal marketing that challenge this assumption. Boutique is not always the winner; deep sector expertise of large managers can be a bonus.

Secondly, assume one must live with long term volatility of around 20%, though with much variation. Managing the allocation is not only the risk but also the unexpected variability. It’s reminiscent of the ditty by the wonderfully named Henry Wadsworth Longfellow: ‘There was a little girl, who had a little curl, right in the middle of her forehead. When she was good, she was very good indeed, but when she was bad, she was horrid.’

Small cap is not always a recipe for richness. The ASX small cap index is known for a laundry list of speculative mining stocks and therefore, as an index, has under-performed its large counterpart. It also means beating the index should be more readily achievable, a point not to be ignored when there are performance fees involved.

What makes a good small cap manager?

The key may be in the interpersonal skills rather than the analytical. One assumes that the intent of allocating to small cap is to ride the wave of growth as a company enters the bigger stage.

Excessively precise forecasts are a fantasy. The profit and loss may be irrelevant. Rather, the focus is the cash flow and balance sheet. A cursory glance at the cash flow can be illuminating in its detachment from the P&L, sometimes laughably so. Balance sheets are the reality check on the cost of achieving ambitions. The problem is that they are infrequent and can be misleading in the short term.

The CEO and CFO are inevitably critical. A bit of psychology skill may the most useful part of a fund manager team. Most small company executives will talk huge ambitions and confidence in their offer. That is not a bad idea, as this is what makes the company the great investment it should be. Yet excessive exuberance and over-promising is a poisoned chalice. Efforts to please investors, stock option exercise, and over-confidence lead to expectations that tend towards too much revenue versus cash flow and managing the balance sheet.

The character of the CEO is possibly the most important judgment. Then it boils down to the business and what it is aiming to achieve. Understanding competitors, or these days, disruption, takes a fair amount of digging around. Another layer is the board, renumeration, especially via low-hurdle options, and staff turnover.

Performance data suggest that there will be some very ‘off’ years for every small-cap fund manager, most likely due to a reliance on a relatively small number of high-conviction holdings. The effort put into gaining confidence in a relatively unknown company can blindside the manager when this thesis is plain wrong. Generalising again, relative under-performance in weak years for small-caps versus huge gains in exuberant periods indicates the attachment to bullish management.  

The balance is in the fund manager that has a humanistic view, a decent understanding of the business proposition and willingness to move on quickly when things are not as expected.

The difference to big-cap managers is more than nuanced. Large companies are fearfully structured these days. No words slip outside the corporate relations, boards are box-tickers and industry trends are far from novel. Style factors can be the sole determinant; valuations have foundations.

Selecting a small-cap manager is more art than science. Recognising new vogue trends, foresight versus the sceptics, can matter more than much of the traditional data. Allocations should be mindful of the required outperformance to the index to compensate for its structural flaws, usually high ICRs (indirect cost ratios) and volatility.

Giselle Roux

Giselle Roux is one of Australia's most well-known and highly regarded investment strategists, having held the role of Chief Investment Officer at both Escala Partners and JB Were. She has also held a number of senior equities analyst and investment banking roles including with Citigroup, Bank of America Merrill Lynch and McIntosh Securities. Giselle is a host of Inside Network events, a member of the Advisory Committee and regular contributor to the Inside Adviser and Investor publications.