Morningstar today released its Sector Wrap-Up for Australian smaller companies funds. This covered 38 strategies and about 80% of assets under management in the sector. Morningstar’s independent investment research is subscriber-paid rather than issuer-funded.
Key Findings
• Funds that achieve Morningstar Analyst RatingsTM of Gold, Silver, or Bronze are designated Morningstar Medallists. We allocated one Australian small-cap strategy the highest-possible Analyst Rating of Gold – BT Smaller Companies. We made a further 10 Silver – Bennelong ex-20, Eley Griffiths Group, Fairview, Hyperion, Ironbark Karara, Mirrabooka, NovaPort, Pengana, Schroders, and SGH ICE. Twelve others achieved Analyst Ratings of Bronze.
• We upgraded two strategies – CFS Wholesale Small Companies from Neutral to Bronze, and SGH ICE from Bronze to Silver, because of the effective leadership and consistent approach of their respective portfolio managers, Dawn Kanelleas and Callum Burns. We downgraded four – Acorn Microcap from Neutral to Negative, Celeste from Silver to Bronze, Invesco from Bronze to Neutral, and Kinetic from Silver to Bronze, largely because of investment team instability and our diminished conviction.
• We initiated coverage on one strategy, OC Premium Small Companies, because of our confidence in the disciplined team and methodical process. We ceased coverage of one strategy, Aberdeen Small Companies, because of coverage criteria issues.
• The argument is sometimes made that small-caps exposure is not necessary for a diversified and well-structured investment portfolio. This line of reasoning is often predicated on rudimentary analysis of index performance, rather than fundamental scrutiny of individual active small- to mid-cap portfolio composition and approaches, which have enabled fund managers to consistently trump the index.
• Although the mining and energy sectors remain a field of broken dreams, the majority of active small-cap strategies continue to successfully navigate choppy conditions, and adjusted stock selection accordingly in 2015. Most managers correctly assessed the impact of the slowing Chinese economy on commodity prices, and have steadfastly refused to fall into the value trap of underestimating the mining downturn. The steady but consistent transition away from resources stocks was one factor which enabled many active small-cap managers to significantly outperform the market.
• The small-cap market’s performance over the next three years is likely to be driven primarily by companies in consumer services, technology, telecommunications, healthcare, agriculture, and financial services. Many of our Medallist-rated fund managers have already shrewdly reoriented their portfolios to incorporate significant tilts to these sectors. Ultimately, investors should not be deterred by recent poor performance, but should concentrate on what an active bottom-up manager is able to deliver through the full cycle.
• The initial public offering pipeline continued to surge in 2015, generating a plethora of floats, some good, some bad, and some highly dangerous. An IPO-rich market environment is however positive for small-cap fund managers and investors in their funds, adding diversity and liquidity. We applaud managers that retain a healthy scepticism before leaping into any new stock, particularly when the sellers are private equity or investment banks.
• IPO participation has limited impact on subsequent performance, and is simply one dynamic among many which a small-cap manager has to deal with. The key issue for fund managers is to avoid exuberance, particularly when pressure is being applied by stockbrokers for rapid decisions. Investors and advisers should be very wary of small-cap fund managers that suddenly change their process to justify participating in floats and try to take advantage of a buoyant IPO market to artificially fuel near-term returns. The greatest chance of investment success comes from selecting a fund manager which maintains a highly-disciplined and consistent process throughout the cycle.
