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Small cap stock have high potential

MOST share market analysis focuses on Australia’s large companies and, as a result, neglects the numerous smaller companies listed on the ASX.

To some extent this is understandable. Australia’s top 100 companies represent 85 per cent of the total market value of all ASX-listed stocks and cover the ‘blue chips’ that normally form the bulk of a diversified share portfolio.

However, investors should not overlook the potential for long-term capital growth offered by companies outside the top 100.

Macquarie Funds Management has predicted that ‘small cap stocks’ will outperform every other asset class over the next decade (with the exception of ‘alternative assets’).

It has predicted returns of 13.0 per cent per annum over the next decade, compared with a forecast return of 11.0 per cent per annum from Australian shares generally.

This forecast stands in marked contrast to the pounding that many small cap stocks have experienced over the past 12 months, partly as a result of investors seeking the safety of large, defensive stocks.

Investors wanting to gain some exposure to small cap stocks can either invest directly or use a specialist managed fund.

Most small cap funds define their investment universe as companies outside the S&P/ASX100 Index – by default, this provides an investment universe of more than 1,100 companies.

Funds investing in this manner include AMP Henderson’s Small Companies Fund, Colonial First State’s Future Leaders Fund, ING’s Emerging Companies Trust, Portfolio Partners Emerging Shares Trust and Rothschild’s Five Arrows Smaller Companies Fund.

Perpetual’s Smaller Companies Fund – one of the few small cap funds to post strong positive returns over the past 12 months – has adopted a wider investment universe. It only excludes the top 50 ASX stocks.

However, Perpetual’s Matt Williams said the top performance was driven by stocks outside the top 100, such as Southern Cross Broadcasting, Bristile, Snack Foods, Peter Lehman Wines and Singleton Group.

Another variant is Colonial First State’s Developing Companies Fund, which invests in “very small” companies with a market capitalisation of less than $200 million.

Colonial’s senior portfolio manager Barry Henderson said the $200 million threshold meant that the fund cannot buy shares in the 350 largest companies on the ASX.

He said the focus on very small companies made the Developing Companies Fund more volatile. It has posted a negative return over the past 12 months but was one of the top performers during the past three years.

Some of its best stocks include E*TRADE (which was sold before the April 2000 ‘tech wreck’) Ion, HPAL, ARB, Collection House and Tap Oil.

Mr Henderson also manages Colonial’s Future Leaders Fund, one of the largest small cap funds with more than $1 billion under management.

He dismisses the argument that the limited size and liquidity of small cap stocks is a constraint.

A contrary view has been taken by JBWere Investment Management, which recently closed its highly successful Emerging Leaders Fund to new investors.

JBWere concluded that continued rapid growth of the fund would impede its ability to maintain high returns.

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