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Opportunities continue in small caps?

Structural Biases

Many academic papers such Fama and French (1992) have identified that smaller companies outperform their large cap cousins over the long term. While locally it has been evident with the median Australian small cap manager returning 2.7%** more than the large cap median over 10 years.

What is interesting is that despite this phenomenon being easily observable the excess returns still exists, partly due to both investors and brokers not investing sufficient resources to ‘arbitrage’ away these excess returns.

The chart below examines analyst coverage of the small cap market, which we define as outside the Top 100 largest companies down to a market cap of $50 million.

Source: Ex-100 down to $50m mkt cap. November FACTSET Bespoke Universe Screen

It is clear from this table that the number of broker analysts focused on each small cap is on average half that of large caps. What is also surprising is that just over 300 stocks have no broker coverage.

Changing Landscape in Small cap research

Further evidence comes from a recent paper from Goldman Sachs*** highlighting “The rising information asymmetry in small caps”. This data clearly shows that the number of analysts and broker estimates in the small cap market has been falling consistently in recent years as shown below.

Exhibit 26: Sell-side coverage of small cap has dropped…

The total number of earnings estimated available via Factset for Small Ords members

Source: Goldman Sachs Global Investment Research, FactSet

The lack of broker coverage increases the likelihood of mispriced opportunities arising given publicly available information from company releases is not analysed and disseminated to the broader investor community in an efficient way.

We have also noticed the quality of broker coverage falling with research shifting to “maintenance research” with earnings estimates only updated every six months with company results. This phenomenon is captured in the Goldman Sachs research shown below.

Exhibit 28: The number of ‘fresh’ earnings estimates in consensus now falls ~ 15 – 20% over the 6 -mnts prior to earnings seasons

# of consensus estimates that are less than 100 days old

Source: Goldman Sachs Global Investment Research, FactSet

The lower line in the chart is the number of ‘fresh’ estimates falling significantly (those estimates updated within 100 days before results). Such irregular updates fail to capture the many earnings signals between results, from AGM statements to input price moves and macro-economic data which enable more accurate forecasts.

We believe high compliance and cost burdens for investment banks will continue to see the “brain drain” of quality analysts from broking to funds management – thus exacerbating the trend of increasing inefficiency is likely to continue in small caps.

To ensure we take full advantage of this the Perennial Value Smaller Companies Team has recently grown to 6 analysts. We spend considerable time scouring the market for mis-priced opportunities which we think will deliver excess returns for our investors. A good example would be the investment process for Imdex Limited described below.

How do we take advantage of these structural issues and anomalies in the small cap market?

Imdex Limited (IMD)

On the ground research lead to high conviction 

At the time of investment, our forecasts were earnings of 5 cents per share compared to the one broker covering the stock who had forecast earnings of just 1 cent per share. The stock was clearly neglected and the market was missing the obvious pick up in exploration spend which our Perth based analyst Sam Berridge first detected at the diggers and dealers conference in Kalgoorlie in August 2016. Using this evidence and our bottom up research we initiated a position and then added it after a trip to the MineExpo in the US in October 2016 gave us more confidence.

The number of broker estimates in the market have now increased to 3 and broker earnings estimates have increased significantly – with the recovery in mining services now a mainstream investment theme.  As a result the stock has significantly re-rated delivering good returns for our investors.

We are seeing more of these opportunities presenting despite the strong increase in the market recently – this is a key reason why the Perennial Value Smaller Companies team was able to deliver a 28.8% return some 4.6% better than the benchmark return of 24.2% for FY18.

With IPO’s growing the investable small cap universe each year we look forward to finding more of these investment opportunities for our investors in the years to come.


** Source Mercer Survey May 2018

***Goldman Sachs “No Small Matter; Six Key Themes for Small Cap Managers” Matthew Ross 23rd March 2018