Small-cap stocks should be more attractive than ever, with readily available investor information and a cooling of residential property along Australia's east coast hitting some of the biggest ASX-listed companies, says Marcus Burns, portfolio manager, Spheria Asset Management.

Spheria's Australian Smaller Companies [15723] fund has a Bronze medal and four-star rating from Morningstar.

"This strategy adopts a sensible approach to small-cap investing in Australia, focussing on companies with strong cash flow generation and sound balance sheets," says Morningstar manager research analyst Michael Malseed.

"This quality filter provides a risk backstop, which allows the team to look at a wide range of opportunities across both the growth and value spectrum," he says.

Giving some insight on the approach his team follows, Burns is quite bearish on some of the larger "darlings" of Australian investors' portfolios.

"I think there's inherently more risk in [Australian banks] than people think, and then you've also got resources stocks, which account for over some 65 per cent of the market in terms of their market capitalisation ... there are a lot more sectors you can be exposed to if you're not concentrated solely on large caps," he says.

"At a time when information is readily available ... with a lot more information via the internet, a lot more material published for SMSF investors and retirees, and we're finding, from talking to financial planning groups, that investors are cleverer, better informed, and more engaged than they were five or 10 years ago."

Cashing in on retail

Some investors may raise their eyebrows at Spheria's high weighting towards consumer cyclical companies--which account for almost 30 percent of its overall portfolio--particularly given the headwinds of Amazon's looming entry and ongoing wage pressures.

"I think everyone's gotten so frightened by the condor [of Amazon], they've forgotten to check the fundamentals. We bought more consumer discretionary stocks after the sector was smashed by the Amazon concerns," Burns says.

"Secondarily, quite a few of the names had Amazon concerns, plus they had some pretty poor trading."

He points to bedding retailer Adairs (ASX: ADH), Telstra-licensed retail store operator Vita Group (ASX: VTG), and Beacon Lighting (ASX: BLX) as examples.

First, second and third order

"Most people with smalls seem to act very one-dimensionally, but they forget there's second and third-order effects," he says.

According to Burns, the basic perception that Amazon is bad for Australian businesses is a first-order effect. He believes this is accompanied by evolution among the incumbents--a second-order effect--and the pricing in of changing market conditions to their share prices--a third-order effect.

"As long as your product isn't directly comparable to something Amazon sells, you've got some scope to differentiate yourself ... the less differentiated you are, the more likely you are to get hit; but the more differentiated, the more likely you are to evolve and survive," Burns says.

"People forget those three things to consider. It's not just news flow. Our view is that a lot of investing in small caps has become news flow driven, and not really analysis driven," he says.

Not for the faint-hearted

"We recognise that small caps are considerably more volatile and potentially more risky than the larger caps, in some ways, particularly if the market turns down ... it's very hard to raise capital in a small cap, for instance," Burns says.

"And we know that in the harder times, small companies are going to do it tougher than the larger ones, so if companies don't have free cash flow, or are particularly highly geared, we view those as very large risks. We try to pick from among the less-risky stocks."

This is a core part of Spheria's process in assessing whether companies make the cut for its Australian Smaller Companies fund.

"We believe that through cash flow you can actually measure the value of a company ... all the great investors--Howard Marks, Warren Buffet, Ray Dalio--they look at cash flow into the future ... if you don't have that, how do you value it?"

Burns believes this metric for assessing smaller companies can reveal both defensive and offensive characteristics.

"What we view as really speculative investing is focusing on high-growth but loss-making companies," he says.

"Smalls is an exciting place to play ... as long as you're investing, rather than speculating, I think it's a great place to be.

"You're also going to get some great companies that grow from small caps to become large caps. Dominos (ASX: DMP) was a small-cap once, as was Magellan (ASX: MFG) and A2 Milk Company (ASX: A2M), which is a $5 billion company that will soon become a large-cap ... if you find these gems, you can make some incredible returns."

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Glenn Freeman is a senior editor at Morningstar.

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