With the amount of gloom and uncertainty around at present, it is tempting for investors to throw up their hands and move everything into cash. But despite periods of extreme market turmoil in recent years, it is comforting to see that over the longer term, the traditional risk/return relationships we have become accustomed to have held true.
Looking back over the past 10 years, equities have outperformed cash, whilst small caps have outperformed their large cap peers.
| S&P ASX 200* | S&P ASX Small Ordinaries* | |
| 30/09/2002 | 1.0% | 7.3% |
| 30/09/2003 | 11.4% | 25.6% |
| 30/09/2004 | 20.7% | 20.6% |
| 30/09/2005 | 32.2% | 30.0% |
| 30/09/2006 | 16.0% | 16.7% |
| 30/09/2007 | 32.4% | 36.7% |
| 30/09/2008 | -26.8% | -34.5% |
| 30/09/2009 | 8.3% | 6.3% |
| 30/09/2010 | 0.6% | 6.6% |
| 30/09/2011 | -8.6% | -12.1% |
| Annualised return | 7.2% | 8.2% |
| Standard deviation | 13.4% | 18.8% |
| Source: Bloomberg, Zurich Investments |
*Accumulation index
As many battle to ensure their super pool is large enough to achieve their financial goals once they reach retirement, most clients will generally require growth from their investment portfolios. “Risky assets” will therefore have to play a part in addressing longevity risk.
The higher levels of volatility associated with the small caps market has led to some avoiding the sector altogether, particularly in uncertain times. As many seasoned fund managers will attest however, this is often the period offering greatest opportunity.
The big world of small companies
The Small Ordinaries Index has achieved attractive returns over the longer term. That being said, simply looking at what the index has done can be misleading. Active small-cap managers have had phenomenal success at outperforming the benchmark over time.
The large number of under-researched companies in the universe means managers with the ability and willingness to “pound the pavement” can find a portfolio of hidden gems, with strong growth potential and attractive valuations. It’s easy to forget that companies like CSL, Fortescue Metals and Flight Centre all began life as small-cap companies.
Over five years to September 2011, even the average fourth-quartile small-cap manager outperformed the index by 3.35 per cent a year (whilst the median manager outperformed by 4.66 per cent a year). Not too many investors actively seek out the median manager (let alone a fourth quartile one); but even if that’s what you ended up with, the results have been pretty impressive.
The risk/reward trade-off
But it’s not just about the headline return number. A sometimes under-appreciated characteristic of highly skilled portfolio managers is their ability to analyse risk effectively. Avoiding the losers is one of the most important aspects of building wealth over time, as just a few bad decisions can undo the benefits of numerous good ones.
This begins with sustainable earnings
Judging whether earnings are sustainable requires a deep understanding of both the macro and micro risks to a company’s earnings. Take current commodity prices as a perfect example. Whilst it is likely that commodities are in a period of structurally higher prices due to strong demand from the emerging markets, making valuation assumptions for resource companies based on commodity prices remaining at all-time highs is fraught with danger.
Rather than looking at spot prices, we believe the industry cost structure is a more relevant measure when assessing the downside potential for a commodity price. Let’s use copper as an example.
Whilst most copper companies may appear attractive with a copper price of $4 a pound, many would quickly start to look expensive if the copper price were to fall significantly. At a price of $2 a pound, around 95 per cent of copper production would still be profitable; this suggests a price of $2 would not be unreasonable.
When closely analysing the risks facing the small companies in today’s environment, we tend to find more attractive risk/reward opportunities outside the resource sector, despite its domination of the index. Looking where others are not can often throw up the best opportunities.
Don’t be afraid to put some spice in your life
Using a good, active small-cap manager as part of a diversified portfolio can prove very rewarding for investors willing to take a longer-term view. Although at an index level, small caps tend to be more volatile than large-cap equities, the higher return potential can make it a worthwhile exercise. By pursuing a benchmark-unaware process that takes a very diligent approach to managing downside risk, good managers can also smooth the ride.
For further information on this topic, click here to read a discussion paper by Zurich Investments: ‘A macro perspective to managing risk in a small companies portfolio’.
Matt Drennan is executive general manager of investments at Zurich
