Anticipating tough times, Metanomski and Prescott are searching for companies with strong balance sheets and resilient revenues. For instance, they have invested in major cinema groups because they have found that consumers in recessions are more likely to choose cinema instead of concerts or the theatre as it is a cheaper means of entertainment. Tribeca’s Aylward believes there are cycles when small companies either collectively beat or lag large caps for periods of time. “There is a cyclical element, but we say that that is difficult to pick,” he says. “We believe clients are better off with a permanent allocation and then trying to get the alpha in the small-cap market, which is persistent.” One cause of consistent gains from small-caps, Aylward says, is information arbitrage, which is the ability to gather new information about companies. “Information arbitrage really does exist. Managers who are skilled in picking small-cap stocks can have that information advantage,” he says. Brunker sees little or no support for the buying the “beta” of the small-cap market. Attempts to beat the market usually provide richer rewards. He bases these views on four considerations: 1. Strategic beta: JP Morgan does not support this argument.

It says the evidence for a persistent small-cap effect in Australia is not convincing; 2. Tactical beta: There is some support for the market-timing argument but cyclical conditions are not currently in favour of small-caps at the moment; 3. Strategic alpha: JP Morgan supports the case for alpha potential in small-caps. This is based on evidence of ongoing inefficiency in the sector and the past performance of managers; and 4. Tactical alpha: Because large-cap equities face earnings headwinds, the case for gaining tactical outperformance from small companies is strong. Commenting on the third view, Mercer principal David Carruthers says the median manager in Mercer’s Australian small companies survey (focusing on stocks outside the top 100) has outperformed by 5.9 per cent a year over five years, and 4.7 per cent a year over the 10 years to June 2011. Even the lower-quartile manager has delivered excess returns over many rolling threeyear periods, he adds.

All that glitters The imperative of undertaking proprietary research means active smallcap funds managers develop their own views on sectors and specific stocks. Many, however, such as Simon Conn at Investors Mutual and Shane Livingstone at Legg Mason, currently exercise similar caution about the resources sector. Conn says the “abnormally high percentage of the index in resources” underscores the crucial need for disciplined stock-picking. “There have been two booms and one significant correction in this sector in the last five or so years. Discipline is critical in avoiding much of the speculation within this segment of the market. Livingstone says roughly 40 per cent of small-cap stocks in the S&P/ASX Small Ordinaries Index are in mining and energy businesses. An ancillary sector, mining services, has also grown substantially. “Recent weaknesses in mining services company share prices would suggest an implicit downgrade to global spending on mining projects. But so far, those exposed to mining volumes have seen no weakness in their order books,” he says. Retail stocks send mixed messages. In the same month that big retailer David Jones announced a significant earnings downgrade, Kathmandu, a small-cap business, announced a significant earnings upgrade. “Consumer spending may be weak, which is a challenge for all to face, but there may be other attributes to compensate,” he says. “A vertical business model, strong store rollout strategy, good management and high gross margins could be just the keys to protecting earnings rather than selling out and buying a low-growth utility company.”