The underperformance of small companies on the ASX compared with their larger brethren is stark, not only this year, but over the past decade. The S&P/ASX 300 Small Ordinaries Accumulation Index is down 1.12% over the past year versus a 7.95% increase in the ASX 300 Accumulation Index. And over the past 10 years, small caps have risen 5.1% per annum compared to the ASX 300’s increase of 8.96%.

Better times ahead

Simon Conn, a Senior Portfolio for Small and Mid-Caps at Investors Mutual, told the Morningstar Investor Conference yesterday, that he believes a turnaround in small cap fortunes may be close. Conn manages funds including the Australian Smaller Companies Fund (Silver rated by Morningstar) which has returned 12.2% over the past 25 years compared to its benchmark’s 5.5%.

Conn believes there’s been a flight to quality and liquidity during and post Covid. That’s meant money has flowed into larger stocks at the expense of smaller ones.

Another factor impacting small caps has been money directed towards index and quantitative investing. That’s resulted in companies benefiting from moving into an index and losing out if removed from an index. And it’s led to a greater shift towards momentum investing.

Conn says these things have created valuations for small caps that are depressed. Cheaper valuations are often the prelude for future outperformance, he says.

Looking for quality and value

Conn looks to buy quality companies with four characteristics:

  1. A strong competitive advantage
  2. Recurring earnings
  3. Capable management
  4. The ability to grow earnings, and dividends, over time

Conn wants to buy these quality companies are reasonable prices.

He says one big difference between investing in larger companies compared with smaller ones is that management teams are more important at the smaller end:

“Big companies like CBA and Telstra will survive and prosper under different management teams. Because of the nature of smaller companies, they can be impacted by good management decisions and hurt by poor management decisions, which is why I think it’s important to get close the management of smaller companies.”

Three companies Conn likes

Asked for companies that he finds attractive now, Conn nominates three small caps: SkyCity Entertainment Group (ASX:SKC), Australian Clinical Labs (ASX:ACL), and HMC Capital (ASX:HMC).

Conn says SkyCity has a strong gaming business in Auckland which generates substantial cashflow. The stock has been pummeled by concerns about potential regulatory fines, especially in light of what’s happened at Star and Crown over the past few years. He believes the level of wrongdoing at SkyCity is much less than that of the Australian casino operators and any fine is likely to be at the smaller end.

Conn says SkyCity is well managed, has a solid balance sheet, and appears very cheap. The stock’s enterprise value (market capitalization plus net debt) is around $2 billion, and the property owned by the company in the Auckland CBD has a valuation of $2 billion. That means the current value on the stock is close to the value of its Auckland property alone.

 SkyCity stock chart

Another stock that Conn likes is Australian Clinical Labs. The company is the third largest player in the pathology sector in Australia. Conn says pathology is a good business as blood testing expands with population growth and more things being detected through blood samples.

He says the company’s volumes can grow 4-6% per year, and with a relatively fixed cost base, that flows through to profits. Sensible acquisitions can further grow earnings.

Conn suggests that Australian Clinical Labs has the potential to be the next Sonic, which is the number one pathology provider.

Australian Clinical Labs stock chart

The last stock that Conn mentions is HMC Capital. It’s a real estate fund manager with $8.1 billion in assets. It has two listed REITs: HomeCo Daily Needs REIT (ASX:HDN) and HealthCo Healthcare and Wellness (ASX:HCW).

Conn says the company has strong leadership with realistic goals to grow funds under management.

 HMC Capital stock chart 

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James Gruber is an assistant editor at Firstlinks and Morningstar.com.au