Erik Metanomski is bearish. He believes investors are entering an even tougher market. It is possible that “massive panic” can spread globally as U.S., U.K. and European governments struggle under burdensome public debt, he says. Metanomski, the well-known Australian equities investor who founded MMC Asset Management, has teamed up with David Prescott to form deepvalue funds manager Lanyon Asset Management. They say stock-pickers can profit as Australia nears the end of a “surreal” period in its social and economic history. “Consumer spending grew for 15 years straight on the back of rising levels of leverage that we had never seen before,” Metanomski says. “I don’t think what was occurring then was normal. I think we’re going back to normal. People are still living in the last 10-to-15 years of unprecedented growth in house prices, consumer retail, debt and liquidity to keep prices at artificially inflated levels.” People in the U.S., Europe and the U.K. have experienced this.
“Now Australia is topping out.” This is good news for small-cap funds managers aiming to buy good stocks cheaply – but only if they can stay in business. “Generally, in tougher markets, history tells us the casualty rate is highest among small-cap funds,” Metanomski says. Investors’ conservatism drives them to the liquidity in the large-cap market. But it pays to take risk in the smallcap market, says David Aylward, founder and managing director of small-cap manager Tribeca Investment Partners. He says small-cap investing provides attractive investment opportunities because the companies are typically “under-researched, undiscovered and [are] an opportunity to invest in emerging opportunities”. Market capitalisation in the Australian equity market is very concentrated in the top 10 to 20 stocks, so brokers concentrate their efforts in this narrow band, says Aylward, who’s managed Tribeca’s small-caps portfolio for 12 years. Bottom-up research focusing on small-cap companies – where there is greater opportunity to add value through direct company and industry analysis – can give active managers an edge over a passive benchmark such as the S&P/ ASX Small Ordinaries, he adds.
Debt and buried This investigative approach is needed. Paul Brunker, an equity strategist JP Morgan, says the good days of solid earnings growth among Australian largecap stocks, which was achieved despite their size, may be coming to an end. In principle, the earnings growth of large-cap stocks converges towards the growth rate of gross domestic product (GDP) as industries become mature. It becomes hard for big stocks to outgrow their industries. “What can postpone this evil day is rising margins,” Brunker says. “The 2000s saw exactly this in Australia, as consolidation led to industries becoming more oligopolistic.” But this phase of consolidation has run its course, Brunker adds, and is in some cases reversing. This line of thinking is confirmed by S&P’s research showing that, with the exception of Australian small-cap equities, many active managed mutual funds underperformed their relative benchmark over five years. Guy Maguire, S&P Indices’ head in Australia, says efficiency in the large-cap equity market will remain a “challenging space” for Australian managers, especially because financials and resources are a significant part of the S&P/ASX 50.