The secret to an outperforming ASX small-cap share portfolio: fund manager

Less publicly available information among smaller stocks works as an advantage for this fund manager.

Michael Steele, co-portfolio manager at Yarra Capital Management

Image source: Yarra Capital Management

Ask a Fund Manager

The Motley Fool chats with fund managers so that you can get an insight into how the professionals think. In part 1 of this edition, Michael Steele, co-portfolio manager at Yarra Capital Management, explains the strategies driving the UBS Yarra Australian Small Companies Fund’s ASX small-cap share investment outperformance.

The Motley Fool: How would you describe the UBS Yarra Australian Small Companies Fund to a potential client?

Michael Steele: Firstly, we’re investing in small-cap companies on the Australian securities exchange. That means we’re investing in companies outside of the ASX 100.

Secondly, the stocks we are investing are from a bottom-up perspective. All the stocks we invest in are based on company specific insights that are developed by our investment team.

Thirdly, when you look at our strategy overall, it’s generated really strong outperformance over time. It’s been in operating for the last six years, and outperformed the S&P/ASX Small Ordinaries Accumulation Index by 6.8% per annum.

MF: What about risk management within the portfolio?

MS: Yes, that’s the fourth point to note.

We have a really high focus on risk management within the investment process. Importantly, that comes through in returns. If you look at the volatility of returns over time, it’s quite low with strong risk-adjusted returns.

We do that by considering ESG [environmental, social and governance] risks, and by considering the durability of cash flows. Does the company have a sustainable balance sheet? And also, we look at how our different positions interact with each other.

The final point is we are generally long-term investors. So, we buy all companies with at least a three-year time horizon. If you look at the portfolio, on average we hold companies for four years.

MF: You invest in the smaller end of the ASX. Is there a minimal market cap you won’t go below?

MS: Typically, we want to invest in companies that are outside of the top 100 that have a market capitalisation greater than $250 million. We define companies below $250 million as microcaps, so we don’t invest in them. We have another portfolio manager in the broader team with a focus on microcaps.

MF: What are the advantages of investing in the smaller end of the market compared to the top 100 ASX blue-chips?

MS: Firstly, there’s a larger information inefficiency. There’s a much higher potential for an alpha, or outperformance, in the small-cap part of the market because there’s much less research and publicly available information. We add value by doing our own research and understanding companies, compared to the ASX 100, where there’s a much more efficient and researched market.

Secondly, small-cap companies, in general, tend to be higher growth. You’ve got companies that are earlier in their lifecycle. They’re developing, they’re growing from a smaller base, they’re earlier stage businesses. And you generally have higher growth and you don’t have legacy headwinds.

And the third point is there’s a much broader investment universe. With ASX small-caps, we’ve got a much larger cohort of companies to look at. And you don’t have a big sector concentration, which provides much more diversity in what you can invest in.

If you look at the ASX 100, 30% of that market is financials, whereas we only have about 10%. So, we’ve got greater flexibility to invest in a range of different sectors and which can generate a range of different outcomes for clients.

MF: Those are some significant advantages. On the flip side, what are the risks of investing in a portfolio of ASX small-cap shares?

MS: If you look back through time, the small-cap market tends to have greater volatility when you have equity market corrections. We seek to construct our portfolio with lower risk by investing in companies that have got durable cash flows and strong balance sheets. So, when you have market corrections, we hope to preserve capital better than the benchmark.

***

Tune in tomorrow for part 2 of our interview, where Yarra Capital’s Michael Steele unveils his fund’s two top ASX small-cap share picks.

(You can find out more about the Yarra Australian Smaller Companies Strategy here.)

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The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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