Investing in Australian Small Cap Equities There s a better way

Investing in Australian Small Cap Equities There s a better way Greg Cooper, Chief Executive Officer, Australia November 2017 Executive Summary This paper explores the small cap Australian Shares market, particularly the relative inefficiencies in the construction of the small cap index as well as the effectiveness of allocating to small caps as a separate strategy or within a strategy that invests across the market cap spectrum. The key conclusions drawn from this report are: - The small ords index has delivered less return and more risk than large cap stocks, which is an anomaly when compared with global small cap markets. This is largely due to the construction methodology (and thus the constituents) of the index. - Whilst small caps have structurally underperformed large cap stocks there have been periods where they have done well which suggests that as a sector they can add value but timing is an important factor. - Large cap stocks have had better earnings growth historically than small cap stocks, no doubt partly due to the way poor quality index constituents are included. - The benchmark for which small cap strategies should be measured is arguably a broad market index as this represents investors real opportunity set in Australian equities. - The alpha shown in surveys, whilst diminishing and subject to survivorship bias, is still reasonable so there is merit in having some exposure to a good active manager that can select good small cap companies. - The choices available to investors that want small cap exposure as well as large cap exposure are: 1) invest in two separate strategies (large cap and small cap) and actively manage the allocation between these strategies or; 2) invest in a strategy that provides a fund (with the requisite skills) the flexibility to invest across the broader Australian shares universe (S&P/ASX 300). - We believe that both options have pros and cons and both should be considered by investors looking to get exposure to small companies in their portfolios. - One overarching point that we would make is that investors should be careful about creating arbitrary divisions amongst similar assets. Who says the 100, 200 or 300 th stock is a sensible break point for any strategy? Investing in Australian Small Cap Equities There s a better way 1

Introduction There are lots of reasons why investors get excited about small cap stocks, particularly in Australia. The significantly larger opportunity set outside of the top 100 companies, the higher growth rates that small companies can achieve, or the myriad of successful individual stock stories that abound. Global academic research has consistently pointed to the long term returns available from the small cap effect relative to larger companies. To some extent these are true there is considerably more economic diversity available by venturing into small cap Australian equities and the potential for some very strong growth stories to emerge. However, the generally accepted approach that we should carve out a specific part of our portfolio for dedicated small cap investment (however we might define that) should be subject to the same rational review as any investment opportunity. In particular, with a large number of managers offering what look like exceptional track records, or the current press around the latest LIC/LIT opportunity not to be missed, it s easy to miss a bit of the wood for the trees. While many investors in Australia take a decision to structurally overweight small cap stocks given the sector and stock concentration in the large cap index, our analysis suggests that a separate allocation to small cap isn t necessarily the best or most cost effective way to achieve this. In this paper we present three primary reasons why an alternative broad cap exposure is a more rational alternative. In particular we address: 1. the performance, risk and constituent characteristics of the small cap index in Australia being quite poor, and hence an active approach being essential and highly justifiable in this part of the market; 2. current and historical valuations highlighting the degree to which the small cap effect can be better captured and the need for flexibility across the market cap spectrum; and 3. active returns in dedicated small cap portfolios being sufficiently variable relative to the broader market to justify a rethink in the approach that small and large cap should be arbitrarily separated. The small cap index is a dud index. There is no small cap effect in Australia Ultimately the decision to own any sub-set of investments must be assessed relative to the broader opportunity set. With small cap Australian equities that opportunity set is clearly the large cap or broader index. The following two charts show the rolling 10 year performance of the small and large cap (S&P/ASX 200) index along with the 10 year annualised volatility of each index. Investing in Australian Small Cap Equities There s a better way 2

2000 2001 2002 2002 2003 2004 2004 2005 2006 2006 2007 2008 2008 2009 2010 2010 2011 2012 2012 2013 2014 2014 2015 2016 2016 2017 2000 2001 2002 2002 2003 2004 2004 2005 2006 2006 2007 2008 2008 2009 2010 2010 2011 2012 2012 2013 2014 2014 2015 2016 2016 2017 20% 19% 18% ASX 200 Acc 10 Year Rolling Volatility (% p.a.) ASX Small Ords Acc 17% 16% 15% 14% 13% 12% 11% 10% 20% 10 Year Rolling Returns (% p.a.) ASX 200 Acc ASX Small Ords Acc 15% 10% 5% 0% -5% Source: Schroders, Global Financial Data. Returns from 1 Jan 1990 for S&P/ASX Small Ords and S&P/ASX 200 (All Ords before 1/4/2000). Rolling volatility based on annualised monthly returns. Put simply, at an index level it simply hasn t made sense to own the small cap index relative to the large cap index over any reasonable time frame, let alone once we account for the risk of small caps being pretty consistently 25% higher than that of large caps since the GFC. The long term drag from small caps in Australia relative to large caps has been in the order of 2.8% p.a. since 1990 (bearing in mind we use the All Ords prior to 1/4/2000 which includes small cap) and 4.3% p.a. over the last 5 years. However, this is not to say that there are not significant opportunities in small caps from time to time the following chart highlights the one year performance differential of small caps versus large cap stocks. Investing in Australian Small Cap Equities There s a better way 3

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 1 Year Rolling Return Difference 30% 20% Large Cap Outperforms 10% 0% -10% -20% -30% Small Cap Outperforms Source: Schroders, Global Financial Data. Returns from 1 Jan 1990 for S&P/ASX Small Ords and S&P/ASX 200 (All Ords before 1/4/2000). While large caps have structurally outperformed, the performance differentials between small and large cap Australian equities have been significant and highly cyclical, representing a potential for additional value add. As such, we would suggest that investors should look at the asset class in aggregate rather than having a structural weight to a subsector of the asset class that has shown significant, consistent underperformance and considerably higher risk. While this may be implemented in separate allocations, investors should at least consider a more active approach to the relative weights in large and small caps. Why does the small cap index structurally underperform? Australian market indices have a unique history with the Australian Securities Exchange (ASX) setting construction rules around the particular circumstance of the Australian market. Indices were set up to reflect the needs of the local capital markets - in particular for small companies to be able to raise capital. The nature of the local market meant that many of these companies were non-revenue generating mining companies who would raise capital for the purpose of exploration or mine development - and in the absence of a venture capital industry this capital was sought through the listed company stock exchange. So unlike many other markets (detailed below), the Australian market indices were built around, at times, a large number of non-revenue or profit generating companies and this methodology was continued after S&P Dow Jones took over the ASX index business in April 2000. Despite having strict rules in other markets around current profitability and financial viability, when S&P Dow Jones took over the ASX indices (now known as S&P / ASX) there was no change in the index construction process that considered financial viability as a key determinant of index inclusion. When looked at through an active small cap equity manager lens, one of the most effective portfolio construction methods was to avoid the losers - which in the Australian market (outside occasional periods of speculative excess) were often embedded in these loss making index constituents. There is no question that given the poor index construction methodology employed in this part of the market investors should actively manage this exposure. But don t small caps offer much greater earnings growth prospects? Interestingly and despite the offshore evidence to the contrary, the answer for Australia is no. The chart below shows the relative actual earnings growth of small and large cap companies over the 10 years since 2007, with data rebased to 1 from Nov 2007. Investing in Australian Small Cap Equities There s a better way 4

1.1 1.0 Relative Earnings Growth S&P/ASX 200 ASX SMALL ORDINARIES 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Source: Thomson Reuters Datastream, From 1 November 2007 It is clear from the chart that over the last decade large cap earnings have significantly outpaced small cap earnings, albeit within each market there will be areas where we have seen significant earnings growth for a period of time. The assumptions that the small cap effect exists in Australia at an index level as returns have been better and that is a function of better earnings growth is, put simply, false. Again, we would suggest that flexibility here is the key to exploiting the opportunities that can and do arise in small caps from time to time this means both actively managing the small cap exposure and actively managing the allocation to that exposure. But the average active manager in small caps does such a good job? True (until recently), the average active manager in Australian small caps has shown a startling propensity to outperform the index. Our view would be that this is due in a large part to the inefficiencies in the index construction methodology, among other things. The Mercer Australian Small Companies survey data shows the median small cap manager has outperformed before fees by 7.32% p.a. over the last 10 years (albeit there are only 23 managers with 10 year data versus 45 managers in the survey today). Clearly if the index is so poorly constructed we should expect a level of outperformance from active management, albeit we need to adjust for the significant survivorship bias in these results. Importantly however, we should at least consider the fees we pay for that outperformance as being better structured if they were against the broader opportunity set, not just the small cap index. The chart below shows the rolling 3 year outperformance of the median Australian small cap manager after adjusting for (some) survivorship bias. We consider this against both the small cap index and against the broader S&P/ASX 200 index for comparison. Most standard surveys only include managers with a track record up until the date of the survey they exclude managers who may have had a strategy that closed during the period. In some cases this can be managers who have done extremely well, closed to new business and removed themselves from the survey. More often than not it is managers who have done poorly and closed and the strategy 1. In total 1/3 rd of the universe has disappeared in the last 10 years. The net result of this can be a significant bias upward to the standard survey results (e.g. our 30 Sep 2017 figure is a median excess return of 1.1% p.a. vs 2.2% p.a. for the unadjusted Mercer survey). Our results below are based on all managers who have at least an 18 month track record and include managers in the calculation up until the date they remove themselves from the survey. 1 Full disclosure, Schroders closed its small cap strategy in April 2016, albeit after a period of significant outperformance. Investing in Australian Small Cap Equities There s a better way 5

May-06 Oct-06 Mar-07 Aug-07 Jan-08 Jun-08 Nov-08 Apr-09 Sep-09 Feb-10 Jul-10 Dec-10 May-11 Oct-11 Mar-12 Aug-12 Jan-13 Jun-13 Nov-13 Apr-14 Sep-14 Feb-15 Jul-15 Dec-15 May-16 Oct-16 Mar-17 Aug-17 0.15 Median Small Cap Active Manager Rolling 3 Year Excess Return (vs both large cap and small cap index) 0.1 0.05 0-0.05 Median Small Cap Active Manager 36m Excess Return (S&P / ASX 200 TR) Median Small Cap Active Manager 36m Excess Return (S&P / ASX Small Ordinaries TR) -0.1 Source: Schroders, Bloomberg, Pre Fees While at times this outperformance has been significant (against both indices), this is somewhat flattering relative to large caps given the significant (circa 5% p.a.) underperformance of the small cap index relative to large cap over this time period. Our point here is that the decision to allocate assets around some arbitrary cut-off by stock number can lead to quite varying results. Somewhat more importantly for investors, the propensity of managers to utilise performance fee structures vis a vis the small cap index has meant that significant gains have accrued to managers of these portfolios as all of the analysis above is before fees are taken into account. Our analysis of the fee differential between small and large cap managers is shown below. We note that the fees on small cap portfolios can be quite significant in absolute terms, and are on average 60% higher than that for large cap portfolios. While at a base fee level there is some justification for this given the relative size of assets that can be managed in each market cap segment, we would suggest investors should be wary of the potential for large performance fees to be accrued versus the poorly constructed small cap index. This is further magnified on a year to year basis with outsized performance fees being achieved, hence the wide range of outcomes in the chart below. Investing in Australian Small Cap Equities There s a better way 6

6% Active manager ICR 5% 4% 3% Average 2% 1% 0% Large Cap Source: Schroders, Mercer, 10 years to 30 June 2017 Small Cap Valuations Unsurprisingly valuations on small cap and large cap companies can vary significantly over time and at present small cap P/E s at 18.7x are relatively high compared to history and higher than large cap at 16.8x. The chart below highlights the variability of both small and large cap P/E s over the last decade. 25 Price/Earnings Adjusted S&P/ASX 200 - DS PER 20 15 10 5 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Source: Thomson Reuters Datastream While both have drifted up (like all asset prices) over the period, small cap valuations have shown a greater variability (which could be a function of price variability and/or earnings variability) relative to large cap. Interestingly, if we constructed a very simplistic analysis of starting P/E differential between large and small cap and subsequent 3 year performance differential we get the results shown in the chart below. Investing in Australian Small Cap Equities There s a better way 7

Large cap has higher P/E and underperforms over next 3 years Difference in P/E vs Subsequent Difference in Performance over 3 Years (% p.a.) 8 6 4 2 0-10% -5% 0% 5% 10% 15% 20% -2-4 Large cap has higher P/E and outperforms over next 3 years -6-8 Small cap has higher P/E and underperforms over next 3 years Source: Thomson Reuters Datastream, Global Financial Data, Schroders Analysis For reference, as of mid-november 2017 we are at -1.8 in the chart above. In summary, there is a distinctive trend towards higher valuations in small cap leading to subsequent underperformance relative to large cap, yet higher valuations in large cap not necessarily leading to underperformance relative to small caps. On this analysis it clearly makes sense for investors to explicitly consider the valuation differences between small and large cap stocks in making their investment allocation decisions. Once again, investors would be better served by considering the total Australian equity opportunity set in and making relative value decisions across the entire market cap spectrum rather than specifically focussing on small (or indeed large) cap stocks only. Investing in Australian Small Cap Equities There s a better way 8

Conclusion: there is a better way An objective look at the opportunities presented across the small and large cap Australian equities market suggests that segmenting the allocation by market cap (as defined by some arbitrary stock number) isn t necessarily the best way for investors to manage their portfolio. While investors may wish to consider a bias towards smaller caps to take account of the greater economic diversity from this part of the market, we present a number of reasons why an alternative broad cap exposure is a more rational way to structure a clients aggregate Australian equities exposure versus separate small and large cap portfolios. In particular, we conclude that: 1. The small cap index is poorly constructed and suffers from significant structurally lower long term performance, higher risk and poorer earnings growth characteristics. 2. Active management of this part of any Australian equity exposure is both essential and rewarding. 3. The appropriate benchmark against which performance should be measured and fees calculated is a broader market index or the large cap index rather than a specifically small cap index as this is more representative of the opportunity set and removes the bias created by an arbitrary index cut-off. 4. The performance differentials between small and large cap stocks, while biased in favour of large cap, have shown significant historical variability and this represents a greater opportunity for investors with broad cap research capabilities to add value. As such, in our view the choices available to investors that want small cap exposure as well as large cap exposure are: 1. invest in two separate strategies (large cap and small cap) and actively manage the allocation between these strategies or; 2. invest in a strategy that provides a fund (with the requisite skills) the flexibility to invest across the broader Australian Shares universe (S&P/ASX 300) We believe that both options have pros and cons and both should be considered by investors looking to get exposure to small companies in their portfolios. At Schroders, we offer a more diversified broad cap approach with a significant exposure to stocks outside of the top 100. The structure of our unconstrained strategy ( Schroder Equity Opportunities Fund* ) is premised on our view that relative size as the single determining factor behind the relative attractiveness of a stock has a weak linkage to the economic fundamentals of a business, and the relative investment merits of that company. Our approach is not wedded to either large or small caps but rather takes an active exposure to all capitalisation segments of the market, and not simply the structural bias inherent in, say, a standalone small strategy. As such, using the full breadth of the universe and departing from benchmark weights based upon assessment of investment merit continues to be a potential source of alpha for active investors. Our unconstrained approach is also manifested in the way we structure our team where stock coverage is allocated to each analyst on a sector basis and extends down the market cap spectrum to include large, mid, small and micro-cap stocks. We believe this integrated approach to research is superior to a market cap based approach as it enables deep industry knowledge to be shared. The overriding factor in dictating stock inclusion and position size is the desire to maximise exposure to high quality businesses at attractive valuations. Avoidance of both poor quality and overvalued businesses should enable returns above those of any size-determined indices (either large or small) over the longer term. *As of October 2017, the Schroder Equity Opportunities Fund had 35.7% of its equity exposure outside of the ASX 100, while the attribution since inception demonstrates contributions from all parts of the capitalization spectrum. Investing in Australian Small Cap Equities There s a better way 9

Disclaimer Investment in the Schroder Equity Opportunities Fund ( the Fund ) may be made on an application form in the current Product Disclosure Statement, available from the Responsible Entity, Schroder Investment Management Australia Limited (ABN 22 000 443 274, AFSL 226473) ( Schroders ). This Report is intended solely for the information of the person to whom it is provided by Schroders. It should not be relied on by any person for the purposes of making investment decisions. Total returns are calculated using exit price to exit price, after fees and expenses, and assuming reinvestment of income. Gross returns are calculated using exit price to exit price and are gross of fees and expenses. The repayment of capital and performance of the Fund is not guaranteed by Schroders or any company in the Schroders Group. Past performance is not a reliable indicator of future performance. Unless otherwise stated the source for all graphs and tables contained in this report is Schroders. Opinions constitute our judgement at the time of issue and are subject to change. This report does not contain and is not to be taken as containing any financial product advice or financial product recommendation. Investing in Australian Small Cap Equities There s a better way 10