Australian Small and Mid Cap Companies

Market capitalisation, a multiplication of a company’s share price by the number of outstanding shares, is commonly used to rank companies on indices around the world.  Well known capitalisation indices in Australia include:

1. S&P/ASX 100 Index; Australia’s largest 100 companies. Approximate market cap between $130bn to $3bn.
2. S&P/ASX 300 Index; a broad-based index covering both large and small caps. Approximate market cap between $130bn to $100m.
3. S&P/ASX Small Ordinaries Index; this includes companies in the S&P/ASX 300, but outside of the S&P/ASX 100. Approximate market cap between $3bn to $100m.

There are also less well-known indices, such as the S&P/ASX 50 Index which comprises the largest 50 companies, and the S&P/ASX MidCap 50, which includes companies within the S&P/ASX 100, but not those within the S&P/ASX 50.

Due to the concentrated nature of the Australian share market, roughly 76% of an ASX 300 portfolio – and fund manager’s attention – would be invested in Australia’s top 50 companies. The remaining market capitalisation of the ASX 300 is split roughly evenly between mid caps (13%) and small caps (11%). Such a relatively small exposure means that investors may be missing out on a rich seam of successful, growing companies which characterise the mid cap space.

Mid caps have a number of attractive characteristics for investors. Not least, they have outperformed the S&P/ASX 50 Index over one, three, five, seven and ten years as at 30 June 2020. Despite this consistent outperformance, mid caps usually comprise only a small proportion of broad-based portfolios which invest in the S&P/ ASX 300, and are omitted altogether in small cap portfolios which are limited to the S&P/ASX Small Ordinaries Index.

An important characteristic of the mid cap universe is the sector diversification it offers investors. Most apparent is the reduced exposure to the Financials and increased exposure to Australia’s growing IT sector. Mid caps also provide relatively more exposure to Communication Services, Consumer Discretionary and Industrials than large caps. Because mid cap sector exposure is more evenly distributed across market sectors, they are less susceptible to movements due to macro themes, such as weakening commodity prices. This particularly suits bottom-up stock pickers, as good companies are rewarded on their merit, rather than the prevailing market sentiment. 

Most stocks in the large cap S&P/ASX 100 Index are extensively researched by the professional investment community. They are mostly well known, mature companies with a large shareholder base. Investors like to hold large, mature companies because they are generally considered to be more predictable and less risky than their small cap counterparts. In contrast, small companies tend to be less well researched and understood. This provides opportunity for skilled small cap managers to identify - through their own extensive research, resources and experience - companies that have the potential to be future leaders, and companies that have the propensity to fail. By picking the winners and avoiding the losers, there is potential for significant generation of above market returns.

There are many high-quality small companies operating across all areas of the Australian economy. Some of these companies will one day grow into large, mature businesses. Identifying these stocks at the beginning of their journey provides investors with the potential for significant capital growth along the way. As small companies flourish, revenue and earnings growth are typically expanding at their fastest point in the company’s lifecycle – growth that larger, more mature companies would find difficult to replicate.

On the flip side there are many poor-quality companies in the S&P/ASX Small Ordinaries Index. Just as some companies will become large, successful businesses, other companies will spend years floundering, or fall victim to unfavourable market conditions or poor management decisions. Investing in these companies can result in significant (or total) capital loss.

The S&P/ASX Small Ordinaries Index has higher volatility than the S&P/ASX 100 Index, but has potential for strong growth with the stock selection expertise of a professional small cap manager. 

In the S&P/ASX Small Ordinaries Index, the negative returns from numerous low-quality companies often erode the value created from more successful businesses. This means attempts to mitigate risk by diversifying across the index, for example via passive investments or low active share, is often not the optimal strategy for investors with regards to the risk/reward outcome. The comparison of returns from the S&P/ASX 100 Index and S&P/ASX Small Ordinaries Index is too simplistic for one important reason; the index returns ignore the impact of above market returns that active managers can produce, which can be particularly significant in small caps.

Investors should consult with a financial adviser to discuss whether an investment is appropriate for an individual’s investment objectives and risk appetite, and to assess a fund manager’s track record and risk management process.