Originally published by UBS Asset Management
Reporting season for Australian small companies is almost upon us. Buckle up everyone as the early signs are pointing to continued volatility. But this is not the time to cut and run.
Over any reasonable investment horizon (say 5 years+) small companies should be an important contributor to most long term investors' total portfolio returns. Whilst the asset class is perceived to be higher risk (due to the greater volatility over shorter investment time-frames), an investor with the benefit of time and professional management should be able to ride out much of this volatility. Good investment returns should be what remains. This professional management has never been more important as the upcoming reporting season promises to be a little more volatile than most. For example, since the August 2016 reporting season there have already been more than 60 downgrades and weak trading updates for FY17 issued by Australian small companies.
HEALTH WARNING: The small companies asset class is a challenging one for DIY investors to manage successfully. The higher risk (and commensurate higher returns) and thus the greater ongoing due diligence required when investing in small companies is something that in most cases should be left to the professionals – such as ourselves and other proven asset managers offering sensibly managed and well diversified small company funds. Good asset managers have the luxury of time, size, systems and experience to more effectively manage the risk and volatility of the sector. It's well worth the price of entry for the lower stress and better outcomes. Unfortunately some don't take this advice.
We often see it with some investors asking us or our peers for our best picks. Some retail investors even pulling out their mobile phones at our presentations to take a photo of a slide containing our top 10 holdings. Many will then directly invest in a very narrow selection of these "best picks" - a dangerous "jackpot" mentality.
However, what these investors don’t realise is that:
1. small companies are not a "buy and forget" asset class – things change and often change quickly. It is a full-time job managing small company investments, not something you do after dinner one evening for a couple of hours.
2. a sensible portfolio needs more than 3-4 top picks (often even fewer are chosen by some). A well diversified portfolio needs a sufficient number of holdings to be appropriately diversified. Our fund is one of the more concentrated funds in the market yet it still typically has 30-40 different holdings. This diversification is required so as to ride out the higher risk and volatility that is a characteristic of the smaller companies asset category.
Whilst a direct investor may get away with this type of strategy in the larger caps sector due to their lower volatility and greater business robustness (banks, telcos etc), this is usually not a plan for success when investing in small companies.
Our UBS Australian Small Companies Fund, for example, has been around since early 2004. It has delivered investors an average compound return over that period of more than 12% p.a. (after all fees) 1 . This compares to an index return for Australian small companies over the same period of not quite 5% p.a. (pre fees) 1 . Even over the past 5 years to December 2016 the fund has delivered investors an average compound return of 13.3% p.a. compared to the index return of 4.9% p.a.
Very few DIY investors in Australian small companies would have had the stomach and patience to ride out the volatility seen in investment markets over the past 5 or 10 years and still deliver reasonable investment returns.
Whilst this upcoming reporting season is expected to be more challenging, it will also no doubt throw up new opportunities to buy some great businesses at below their intrinsic long term value. For us, this is not a time to be running for cover but rather to be alert to both the risks and also the opportunities that may present themselves.