The market is holding its breath that the remarkable outperformance of small stocks over larger ones this year will continue, as investors dive deeper down the exchange to find value.

The $621 billion self-managed superannuation fund (SMSFs) sector is betting that riskier small stocks will offset persistent low returns from the 100 largest companies.

Almost one in five stocks held directly in SMSF portfolios are now small and microcap companies, according to SelfWealth, a leading SMSF social networking site. SelfWealth surveyed more than 3000 of its SMSF members for AFR Weekend.

“There has been a significant trend in SMSFs to hold stocks outside the ASX 300,” says SelfWealth managing director Andrew Ward. “The proportion of smaller stocks held by our members [19.2 per cent, by weighting] has doubled in just one year.”

The $621 billion self-managed superannuation fund (SMSFs) sector is betting that riskier small stocks will offset persistent low returns from the 100 largest companies.

Institutional investors are also showing greater interest in small-cap stocks. Australian Foundation Investment Company (AFIC), one of the market’s most conservative investors, signalled its intention in August to increase its portfolio exposure to smaller stocks.

“More fund managers who invest in large-cap stocks are drifting down the market to find faster-growing small companies,” says Pengana Emerging Companies Fund co-manager Steve Black. “It is getting harder to deliver a good return from the top 50 stocks, and justify fees.”

Morningstar Australasia head of equities research Peter Warnes, says ASX 100 companies collectively lack initiative. “The big end of town seems to have gone to sleep a bit. The top 100 are not investing or taking enough risk. The smaller end of the market looks far more vibrant and energetic by comparison. Small-cap management has noticeably improved.”

Outperformance

This weight of money into small stocks is elevating returns and risks. The S&P/ASX Small Ordinaries index, a gauge of stocks broadly ranked 101 to 300 by size, has returned 27 per cent, including dividends, over one year. The ASX 100 index returned 9.5 per cent.

Small Ords are outperforming the ASX 200.

Index quirks explain some of the performance gap. The Small Ords has a higher weighting in resource stocks compared with the S&P/ASX 200 index. That worked against the Small Ords when a bear market in the mining and energy sectors took hold in 2011, but now works in its favour because of a rally in small resource stocks this year.

Also, recent gains in small-cap stocks follow poor relative performance from mid-2012 to early 2016. Over five years, the Small Ord’s annualised 5.1 per cent total return is a third of that delivered by the ASX 100, which benefited from a high weighting in bank stocks.

Moreover, several stocks in the Small Ords are not that small. Stocks such as super administration group Link Administration Holdings, gold explorer Evolution Mining, Mayne Pharma Group, Macquarie Atlas Roads and Metcash, the groceries distributor, are well-established, billion-dollar companies. SMSFs and fund managers are hardly speculating on “the next big thing” when investing in companies of this size.

Nevertheless, the unusual performance gap between small and large stocks is another symptom of a low-growth, low-interest rate environment that is turning investing on its head.

Small stocks typically outperform when risk appetite is rising, the Australian economy is strengthening and the bull market is nearing its peak; not in a volatile, uncertain market when defensive blue chips are usually favoured.

Investment Trends’ 2016 SMSF Investor Report in March found the average SMSF trustee expected the Australian sharemarket to rise by just 2.8 per cent over 12 months. “This is very bearish,” says the firm’s research director, Recep Peker. “In a normal market, the figure is 7-8 per cent and in a bull market it is 12-13 per cent.” SMSF trustees, it seems, are adding more risk to portfolios even though they are increasingly bearish on the market.

Investment Trends’ survey of 3531 SMSFs showed a small drop in the proportion of trustees wanting to invest in blue chips over the next 12 months. The intention to buy small-cap shares held steady at 16 per cent of trustees surveyed. “Blue chips and high-yielding shares remain an important part of SMSF portfolios, but there has been a gradual move away from them in the past 12 months,” says Peker.

Faced with low returns, more SMSFs might be including some speculative shares with their blue-chip stocks to lift returns – a type of “barbell” investment strategy that combines low-risk and high-risk assets to achieve better risk-adjusted returns and is fraught with complication.

Going for growth

The move to small-cap stocks also reflects the changing prospects of Australian industry. “Investors are looking for small-cap companies leveraged to industries that have better growth prospects,” says Pengana’s Black. “The top 50 stocks, in particular, are exposed to banks, insurance, mature telecoms and listed property – industries in the slow-growth lane.”

Expectations of higher earnings growth in small-caps is reflected by higher valuations. Macquarie Wealth Management forecasts an aggregate price-earnings (P/E) multiple of 18.2 times in FY17 for companies in its Emerging Industrials Leaders index. It expects large-cap industrials, including financial and property trusts, to trade on about 16 times.

That means investors are paying a larger premium for small stocks over large ones. Small-cap stocks historically trade at a discount to their larger peers because their operations are less diverse and they tend to have weaker balance sheets and shallower management teams.

The valuation premium is cause for alarm, says Michael Glennon, managing director of Glennon Capital, a specialist investor in small-cap stocks. “There is a lot less value in stocks in the Small Ords index. Weight of money has pushed the [P/E] multiple of larger stocks in the Small Ords too high. We are finding better value looking further down to the microcaps.”

Fat Prophets CEO Angus Geddes says small stocks are expensive relative to larger ones. “There was a lot of catch-up in the Small Ords as resource stocks rallied this year, but the index has run too far. It is the same old story: capital gets attracted to high returns. We still see value in small resource stocks, but cannot see the Small Ords doing as well in the next 12 months.”

However, Morningstar’s Warnes, a tough judge of stocks, believes valuations in small-cap stocks are sustainable. “If anything, large-cap stocks look more overvalued than the small end of town,” he says. “Earnings-per-share growth in FY17 looks a lot stronger for small-caps than it does for large-caps. That tells you the Small Ords has not run out of fuel, but stock selection is critical.”

Small-cap fund managers are finding more value outside the Small Ords in microcap stocks (beyond the ASX 300). So too are retail investors who are delving into the market’s less-charted territories – and swimming with more sharks – in the search of portfolio treasure.