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Small Cap managers crowing

Small cap managers have had a memorable 12 months, with 97% of small cap managers outperforming the ASX Small Ordinaries Index, and that’s after fees.

Over three, five and ten years, the results are equally consistent, with 98% outperforming the index, according to Morningstar data and the Australian Financial Review. Compare that to large cap managers, who predominantly fail to beat the index at any time over the past ten years.

The S&P/ASX Small Ordinaries Index (Index: ^AXSO) (ASX: XSO) is made up of those stocks in the ASX 300 index, but excluding the top 100 stocks, so they are generally regarded as our next best 200 odd companies, and usually tagged as ‘small caps’. Over the 2012 calendar year, the index performance didn’t exactly set a high hurdle rate, returning just 6.6%, compared to the S&P/ASX 200 Index (Index: ^AXJO) (ASX: XJO) which recorded a 21% rise for the year to January 31.

Morningstar co-head of fund research Tim Murphy attributed the superior performance to the sector being less researched and less analysed, giving managers the chance to scout out potential winners.

The average domestic small cap manager returned 21% in 2012 after fees, substantially beating the index.

But before you all rush out and invest in small cap managed funds, you should know that the odds are pretty much stacked in the small cap managers’ favour.

Small resources stocks slumped by 18% last year. Any small cap manager avoiding small resources stocks would see them beat the index, and many of those managers do indeed avoid resources companies altogether. Most small cap mining companies have negative cash flows, high operating leverage, too much debt or a low interest coverage ratio, so few, if any, make it through most managers’ filters.

When you consider the industrials stocks in the small ordinaries recorded a 23% rise in 2012 – that suggests the average small cap manager that doesn’t invest in resources stocks, failed to beat the index (the average manager returned 21%). Maybe they should track their performance against the Small Ords Industrials?

Foolish takeaway

While small cap managers will probably be high fiving each other, giving themselves a pat on the back, and no doubt expecting a nice big bonus cheque for a job well done, investors need to remember that what happened last year is unlikely to be repeated this year or next.  The best strategy (we reckon anyway), is investing in quality companies trading at a cheap price, no matter what index they may or may not be counted in.

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More reading

The Motley Fool’s purpose is to help the world invest, better. Click here now for your free subscription to Take Stock, The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead.  This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson. Motley Fool writer/analyst Mike King doesn’t own shares in any companies mentioned.

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