There are no short cuts for micro-cap equity managers. With no obvious risk positions available, they must dig for new information on underresearched stocks to find buying opportunities while keeping an eye on macroeconomic developments that could overwhelm these positions. Their investors must also have the guts to weather the notoriously volatile sector. PHILIPPA YELLAND reports.

The micro-cap sector has the largest proportion of stocks on the Australian sharemarket – more than 1,700 securities – and consists of 85 per cent of all listed companies. With an aggregate market capitalisation of about $105 billion, it’s a significant part of the index, but one that doesn’t get a lot of attention or is easily accessed by investors. Businesses in the micro-cap sector are also structurally different to large-cap companies – they tend to have less debt, because banks won’t lend to them as readily as larger companies, and the success of companies is much more dependent on the individuals in charge, rather than organisational strength. It’s also a growing sector.

David Bryant, group executive at Australian Unity Investments (AUI), notes that since the company’s Acorn Capital Fund began in 1998, the sector has quadrupled in terms of capitalisation and the average company size has doubled. Standard & Poor’s (S&P) released its micro-caps funds’ ratings last month and two of the stellar performers were AUI and Perpetual, but another outstanding performer is Contango, which chooses not to be on the S&P’s ratings client list. One of the common reasons why these managers are in this sometimes-overlooked space is the alpha opportunities on offer, which are harvested by experienced analysts. This is the first time S&P has released discrete reports on small-, mid- and micro-cap peer groups, says Justine Gorman, an S&P fund services analyst.

The ratings agency defines micro-caps as those companies outside the S&P/ ASX 300. In the 12 months to May 31 this year, she says, mid-caps were the best performing sector at 21.1 per cent, followed by small-caps at 19 per cent, and then micro-caps at 14.4 per cent. Uncertainty remains on the economic front and the market is still shaky, Gorman says, threatening the outlook for microcaps. “Micro-cap funds can deliver stellar performance, but at the same time exceptionally volatile returns. The risk of loss resulting from poorly managed businesses is greater in this segment of the market, therefore strong stockpicking skills from managers is imperative.” Strategies in this sector can only absorb so much capital before they become capacity constrained, and performance fees can be 10 to 20 per cent, she says. “The sector tends to have high tracking errors of 6 per cent plus due to their benchmarkunaware approach.”

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