It might seem straightforward advice, but according to some of Australia’s leading small cap fund managers, investors in the sector could benefit from professional expertise.

“People often hear their mates talk about the fantastic returns they made on one or two stocks, but no one talks about their losses,” says Jeremy Bond, founder and chief investment officer at small caps fund manager Terra Capital.

“The losses are far more prevalent, since while a few small caps make really good returns, most are below par.”

“Small caps” are typically defined as companies outside the Australian Securities Exchange’s top 100, with companies in the S&P/ASX Small Ordinaries index generally having market capitalisations ranging from a few hundred million up to $2 billion.

Among Australia’s 950 small cap stocks, just 79 posted a greater than 25 per cent return a year over the past five years to the end of 2017, of which the average return was a spectacular 447 per cent, says Terra Capital's Bond.

Yet overall, the $111 billion small cap sector delivered a negative 19 per cent return over the past five years, compared to a 68 per cent gain for the $1.6 trillion large cap sector comprising 102 stocks.

However, with an average of just 1.1 analysts per stock in the small cap sector compared to 9.8 for the large caps, small cap fund managers argue there is greater opportunity for value-adding given the lack of analyst coverage.

“We’re trying to find opportunities that are not well understood in the market or well covered by brokers, and by doing that we think you can find assets that are mispriced and therefore generate returns,” Bond says.

“Management, particularly at the smaller end, is vital. There’s a lot to do in a small company and it really depends on the people steering the ship.”

Examples abound of small cap companies that have enjoyed massive gains driven by investor and media hype, before falling back to earth just as quickly.

“In small caps you need a degree of tolerance, but you also need to be able to determine whether it’s a teething problem, a growth problem in the business, or fundamentally a much bigger issue,” Bond says.

“On the upside, it’s important to let the winners run a little bit. There’s always the temptation with a stock that’s up by 30, 40 or 50 per cent to sell, but in the sector in which we operate, if you really believe in the business you can see some really strong returns that can be many multiples of the company over time.”

“We’ve been running for almost eight years, so we’ve been through good and bad markets. Until a couple of years ago the resource market was very tough, with only a handful of stocks performing well each year. Then in 2015/16 we saw the gold sector start to perform, and then the battery thematic started to play out,” Bond says.

According to Bond, it’s not just lithium, graphite and cobalt--changes within the resources sector have also started affecting nickel, manganese and copper miners.

"At the same time, you’ve seen China’s policy changes which have restricted the supply of several commodities including coal and iron ore. Coupled with synchronised global growth, suddenly the resources market is a nice place to be.”

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Anthony Fensom is a contributor to Morningstar Australia

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