Follow the earnings to superior returns in small caps

Australian small cap stocks have failed to live up to their potential in recent times. By definition, small cap companies are generally at an earlier stage of their life cycle with good growth opportunities ahead, and in an environment of record low interest rates and freely available money for companies to expand their operations, it would be expected that they are growing strongly and generating good returns. Some are doing just that, however it may surprise investors that the aggregate level of earnings generated by companies in the ASX Small Ordinaries Index has consistently declined since 2008 when the Global Financial Crisis (GFC) hit.

Source: AMP Capital, FactSet (2001-2019)

Earnings under pressure

There have been a few different factors driving the underperformance of earnings:

• The end of the resources capex boom in 2012-13 resulted in large earnings downgrades in mining and mining services related stocks, which were significant components of the index at the time
• The domestic environment has been challenging for large parts of the economy with cyclical and structural factors affecting the earnings base of both consumer (subdued consumer confidence, e-commerce) and housing (new start declines, rising power prices) related companies
• A number of technology and other high growth stocks have gone through big cost investment programs – investing heavily in sales, marketing, product development and offshore growth to capitalise on new market opportunities. This has the potential to raise the earnings profile in outer years but has resulted in downgraded earnings forecasts in the near term

The overall market has delivered muted growth since 2014, which has reflected a stronger period of earnings growth in mining companies (notably gold stocks), while earnings for industrial companies have flat lined and are virtually unchanged since post-GFC lows 10 years ago.

Small caps versus large caps

The factors highlighted above go a long way to explaining the underperformance of small caps stocks compared to their large cap counterparts over this time period. In fact, since small cap earnings bottomed after the GFC in September 2009, the Small Ordinaries Accumulation Index has underperformed the ASX 200 Accumulation Index by 70% in aggregate. It’s amazing that an index dominated by banks and diversified miners has substantially outperformed an index which has contained material exposure to stocks which have captured investor’s attention over the past few years including technology, Chinese consumer consumption (e.g. infant formula and vitamins), electric vehicles and gold.

Source: AMP Capital, FactSet (2009-2019)

Follow the earnings

The research we have undertaken into small cap returns and our experience in the market shows that earnings drive share prices. Valuation is an important consideration, however it is mean reverting and hard to predict, so we focus on our core strength – forecasting earnings. An earnings-based approach to valuing a stock is resilient to valuation changes and its serially correlated nature makes it more predictable.

Since 2001, the ability to pick a portfolio of stocks that has actually delivered the highest level of earnings growth in the small caps market would have delivered a compound 14% annual return, or a cumulative return of 828% over this period. This compares to an index return of 1% per annum. Obviously forecasting earnings with perfect foresight is impossible, but this illustrates the potential opportunity for active managers in the space who can spend time undertaking detailed fundamental research on a company and get an edge on the market.

Source: AMP Capital, FactSet

The above chart also shows that sell side analysts have added very little value when picking earnings over this period and investing by following consensus earnings leads to underperformance. In fact, since 2001 a portfolio of small cap stocks with the highest growth forecast by consensus has provided a return of -2% per annum, or -29% in aggregate. This isn’t a huge surprise given sell-side analyst forecasts are typically a lagging indicator. This is further exacerbated by the number and quality of earnings estimates in the Australian small cap market falling dramatically over the past few years.

Bigger is better? Not necessarily…

Despite the relatively gloomy picture we have presented for small cap earnings, there is one major reason for optimism in small caps. The median small cap manager has significantly outperformed not only the ASX Small Ordinaries Index, but also the ASX 200 Index and the median large cap manager over a long time period. Investors who have trusted their money with even a middle of the pack small cap manager have seen excellent compound returns over this period. The Australian small caps market is inefficient and not well researched, providing good managers with the opportunity to find new information which gives them an edge in picking stocks.

Source: AMP Capital, Mercer, FactSet (2000-2019)

Key take-aways:

• An investment process which is focused on earnings can lead to significant outperformance
• The need for investors to be benchmark unaware – why invest in a stock just because it is in an index? It’s much better to construct a high-quality portfolio of stocks from all the available options in the investable universe
• The benefit of active management, especially in small caps, which have proven to generate excellent returns for investors over the long term