Are small caps now a good bet?

Australia’s largest listed investment company Australian Foundation Investment Company (ASX:AFI) earlier this week made a bold statement: small cap stocks were now part of the long term investment conversation.

AFI released its yearly statement to the market in late July, reporting in with a net profit figure of $265.6 million, about 9.5% down from the previous year.

The reason was quite obvious – its ‘Fifty Leaders’ segment of the market was down 2.6% for the year, while its ‘small-to-mid cap 50’ was up 16.1%.

AFI was a fund that was over-weighted to the blue chips and larger companies on the market, and it paid the price.

Subsequently, AFI told its shareholders that it has increased its holding in small-and-mid caps to 22% from a 15% share of its portfolio.

The company pointed in particular to the gold sector as a place where value could be found given the current run of gold on the market.

It did add a caveat however that it was not looking at microcap resources companies, which it said were too speculative in nature for a fund which looks to give out dividends.

The focus on the smaller end of the market though mirrors what was happening on the market last year – which Finfeed covered at that time.

For the calendar year to the middle of December last year, the Emerging Companies index (ASX:XEC) grew by 6.25% while the Small Ordinaries (ASX:XSO) Index grew by 0.56%.

Compared with the likes of the ASX 200 (ASX:XJO) which was down by 8.57%, the All Ordinaries (ASX:XAO) which was down by 7.16% and the ASX 50 (ASX:XFL) which was down by 10.32%, the small cap space was a safe haven of growth.

Back then, the comparative growth was read as a function of the strongest small caps surviving a resources wipeout.

Now, however, small to mid-caps are part of the conversation because of the macro picture – at least according to AFI.

“Despite the recent strength of the market,” AFI wrote, “we expect volatility to remain a feature of markets for some time.

“The Australian economy is expected to face more subdued growth over the medium term...this is against the background of a political environment which is making it much more difficult to deliver necessary economic reform.”

The message here is that what were once safe dividend bets are getting harder and harder to find, and while the same headwinds affect the junior end of the market, they just became a lot more attractive in comparison to the blue chips.

Once upon a time the level of risk between a large cap stock and small cap stock was chalk and cheese – so if you didn’t have the money to lose you’d go for the large cap every time.

In this environment though, large caps are starting to be buffeted by headwinds and the downside appears apparent.

The downside has always been there for small cap stocks, but the potential gains on a relative term continue to outpace the larger end of the market.

All of a sudden, small caps don’t seem so dreadful by comparison.

So could 2016 be a breakout year for the small caps?

There seems to be two main ways this year of volatility is playing out:

1. Investors have been piling into gold as low interest rates makes bond investment a bit of a damp squib;
2. Investors looking for yield have actually been taking a second look at smaller stocks.

One approach is safety, the other is greed.

As the Oracle of Omaha, Warren Buffett is oft-quoted as saying “be greedy when others are fearful and be fearful when others are greedy”.

It’s all set up for a somewhat counter-intuitive pile into small caps.

We’re not oracles and we’re not saying that will happen – but it’s worth checking out.