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Finance - Undiscovered gems: smaller companies |
With the share market near record highs, the residential property market in decline and interest rates on the rise, where is a reasonably cautious investor to go?
The good news is that in comparison with previous years, the outlook for this financial year is reasonably bright. The analysts say that the economy is still growing strongly, both here and overseas, and there is no new Bush war on the radar screen (for now anyway).
Of course there is always the X factor that will pop up unexpectedly and throw confusion and uncertainty into the markets. But barring this, company profits should continue to rise.
Many companies however appear fully valued at present with all the near term future growth already factored into the share price.
If we have an efficient market, this is how it should be. But is the market efficient? Have investors taken into account all relevant factors in every listed company? Have they looked at the economy, done the sums and based decisions on future profitability and interest rates? The smart traders say no.
Highly successful investors such as US-based Warren Buffett have made their billions and reputations on the principle that the market is not efficient and that often companies with high potential are overlooked. Buffett and others like him only invest in companies where they believe there is unrecognised value.
This means researching the company thoroughly, looking at its financial details including debt and profitability, its marketing strategy and its future growth possibilities and then working out what the share price should be. If this price is more than the current market price then it is a possible buy.
It was Buffett who practically withdrew from the market during the recent dot.com boom claiming he couldn’t understand what was happening. Why would anybody buy into a company that was not profitable and had no plan about how profitability was to be achieved? He was criticised as being out of touch with the new market era. So much for that claim.
One area where the market is definitely not efficient is the smaller company sector. These companies make up the bulk of the listings on the stock exchange.
Because they are so plentiful and volatile, the major market analysts largely ignore them. They research the top 200 or so companies on the Australian stock exchange for the large superannuation and insurance funds that are not particularly interested in getting involved with smaller companies.
But smaller companies can do well. They are often growing from a small base and tend to leave their run until after the rest of the market has reached its full potential. Over the past year smaller company funds have done exceedingly well. The small company fund run by Credit Suisse for example achieved a return of 61 per cent in the last 12 months. Over two years the return was 27 per cent and over three years 21 per cent.
While not all the smaller funds have done as well as this (there are 33 of them), returns in the high 30s and early 40s was common, with none returning less that 20 per cent in the last 12 months.
The advantage of smaller companies is that they can grow quickly if they get it right. It is relatively easy for a small company to double in size through organic growth. Larger companies run into restrictions relating to market size and competition issues.
In addition smaller companies are often run by their owners who know the business intimately and who are large shareholders. They have a strong vested interest in seeing that the company does well.
The biggest disadvantage of smaller companies is that their share price can be volatile and many of them fail to perform. They may have only one product or service that makes them vulnerable to changes in the market. Because they are small, one to two buyers or sellers can adversely affect the share price.
This problem can be largely overcome by investing thorough a managed fund that spreads the risk over a large number of companies. Most funds restrict their investment to 20 per cent of the company’s capital.
Perhaps the biggest potential disadvantage relates to general market downswings. In the big crash of 1987 for example, many investors in managed funds wanted their money back. Fund mangers found they could sell shares in larger companies but in the smaller company area there was no market at all.
Fortunately this doesn’t happen all too often but it is worth bearing in mind if the market gets wildly over-heated.
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