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Opinion: Small is suddenly beautiful again

By Simon Louisson

Friday 14th May 2004

Text too small?
Suddenly small is beautiful again.

Several funds have been launched lately, attempting to attract punters to schemes dedicated to investing in small stocks.

They all point to figures that show over a reasonable period - say three to five years - small stocks have historically outperformed big ones.

The theory is that large companies have been through their big growth spurt and the bigger they get, the more difficult it is for them to achieve double digit growth. For them, it is usually a case of diminishing returns.

According to Andrew Couch, a fund manager at Salvus Asset Management, which is launching the latest offering, Salvus Strategic Investments, there has been a "gap in the market" in New Zealand. He doesn't accept that too much money is chasing too few companies.

The 86 stocks in the small companies index are capitalised at $3 billion and the value of unlisted stocks weould be many times more.

"Relatively to Australia and the UK, the number of small company vehicles is very, very small," said Couch.

The market was "underdeveloped".

Salvus' research says that not only do small stocks tend to outperform larger established companies, but the New Zealand Small Stocks Index has outperformed equivalent indices in other markets around the region.

"The manager believes the smaller company sector in New Zealand offers inefficiencies in pricing and consequently there are often stocks within the sector which are undervalued," the Salvus prospectus states.

"Using stock selection skills it will seek to invest in these smaller companies with the intention of providing returns in excess of the NZSX Small Company Capital Index."

That index has been flat from 2000 to 2003 but better than falls in most broader indices, and has taken off this year with a 25% gain.

Salvus is seeking to raise up to $50 million and the $1 shares are attached to a warrant giving an option to buy another share at the same price in 2007 or 2008.

Salvus "conservatively" expects returns of over 15% after tax and fees.

That issue follows closely behind Fisher Funds Management's (FFM) Kingfish issue, which raised $58.5 million in March to be invested specifically in small and medium stocks.

It has a similar structure with a warrant attached. The shares are currently trading at 93 cents and the warrants at 15.8 cents.

While not specifically targeting small stocks, Colville Equities also launched this week, seeking to raise $75 million through an IPO beginning on Monday.

Couch says NZX's promotion of the NZAX alternative market has been a big boost for the sector. He confidentially expects the 15 companies listed to grow to 40 within a year.

Gains or losses among small stocks can be dramatic. NZAX-listed Mooring Systems has more than doubled in price this year, for example.

Colville chairman James Ogden said its IPO was tailored to meet demand among "heartland investors" and the fund's aim was to outperform the NZSX-All Gross Index by at least 3 percentage points a year over time.

Colville and Salvus each have a high profile market commentator/analyst on their small board of directors - Brian Gaynor for Colville and Roger Armstrong with Salvus. Both have been outspoken critics both of company performances and the market, and it is a brave test for each to put their money where their mouth is.

Yet another company seeking funds and targeting small and medium companies is Hawke's Bay-based private company Aquiline Holdings, run by former Air New Zealand boss Jim Scott.

It is seeking to raise $90 million by the end of the year, which it will invest in unlisted small and medium enterprises (SMEs). It already has $160 million of assets on its books and with a gearing ratio of around 50%, if it raises the money it is seeking, will have a considerable war chest.

Its sales pitch is to find SMEs with lazy balance sheets, buy cheap, strip out excess capital, and rev them up with new management.

Its unusual method of setting its own share price has been criticised by ASB Securities managing director Tim Preston as based on the "bigger fool theory" in action.

Putting yet more pressure on the sector, FFM has also been appointed by the Guardians of the Super Fund to invest 1.25% of its assets in stocks below the top 10 index. That will give FFM about $120 million to play with by 2006, but at the rate the budget surplus is growing it could be considerably more.

Carmel Fisher's FFM already had about $250 million under management, so she is going to have her hands full finding suitable medium and small target companies.

Fisher could end up with an average of 5% in each of the stocks in the Small Companies Index. Kingfish plans to invest only in between 15 and 25 stocks, while the Fisher NZ Growth Fund is at present invested in around 14 stocks - owning up to 20% of the company in some cases.

Because of the small size of many of the target companies, critics say the funds will distort the price to its disadvantage, both when buying and selling stakes.

Liquidity risks were a fact of life for a small-caps manager, Fisher said recently.

Salvus' Couch said small stocks also suffer from the disadvantage of not being researched by broking houses. Few individual investors have the capacity to do this, but funds such as his would be able to analyse risk and return prospects.

"Investing in smaller companies is not as easy as it may appear."

Infometrics economist Gareth Morgan, who like Gaynor and Armstrong is a newspaper columnist who manages investment portfolios (as distinct from funds), says the popularity of tapping into the small stocks end of the market was simply a function of a bull market.

"They are just trying to hoover up as many funds as they can, because one thing for sure is that the management fees are guaranteed for a set period."

He said there were more new floats in the market since 1987 and the quality was going down.

"If you can take advantage of a bull market when all the money is out there, then you can make yourself a pretty nice job overnight. It doesn't matter what the investments do, they (investors) are not getting their money back, but you're getting your fees."

Both Colville and Salvus have made a point of their low fee structures. Colville's portfolio manager, Milford Asset Management, is claiming only a 1 percent annual fee. And assuming it raises $50 million, Salvus' set-up costs amount to 2.3% and its management fee is 1.25% plus an incentive bonus if it outperforms the NZSX small stocks index.

Morgan remains sceptical.

"The historical record of funds is not flash. If you look at investment trusts generally, they tend to trade at about a 15% discount to the market (below asset backing).

"You have a so-called expert in charge but they tend to be priced at 10-15% less than the underlying securities. Why? The answer is the fees and the uncertainty of the manager who might change the business case a few years out.

"That's the reason why people don't tend to like them."

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