Consistent small caps: they’re out there — just follow the whistle

Many people I meet say, “Oh, small caps, they’re too risky!” I nod and walk on. Small caps do move a great deal more than their larger counterparts, I admit. When the news reports Telstra had a big day, declining 3 per cent, I think to myself, that’s nothing! Double-digit rises and falls are almost de rigueur in a small cap, which I define as an ASX-listed company with a market cap less than $500m.

When you focus on small caps as a whole, you are forgetting that the big advances in reducing risk from investing have been through diversifying that risk, which means holding stocks that complement each other, otherwise known as reducing correlation.

Because the big companies represent the market, to produce more consistent returns you need to buy stocks that are off the beaten track, so to speak. In stockmarket parlance, “low beta”.

Generating exposure to the market through an index fund provides the cheapest form of diversification, but if you want to reduce your risk further, and generate bigger returns, stocks that have a low correlation to the market are worth thinking about.

Before I get to some of these stocks, it’s important to point out that every stock is going to have a correlation coefficient of at least 0.5, which means the influence of the market is 50 per cent or more on its price movement. If a stock has a correlation coefficient of 1, it moves in line with the market. Conversely if it’s -1 it moves in exactly the opposite direction.

You don’t want to pretend that a stock’s behaviour is going to be separate from the market, although through history there might be the odd incidence of this. What you have to do is be careful in selecting stocks that won’t behave like the market, which to my way of thinking includes those stocks that are not expensive.

Certainly, two stocks that have looked cheap, the junior nickel producer Panoramic Resources (PAN) and the sleep apnoea specialist SomnoMed (SOM) have both spiked 40 per cent-plus in recent weeks, the former on a takeover bid from Independence Group (IGO).

For a company like Panoramic it’s not a diversified producer and has had significant problems resuscitating its Savanah Mine in the east Kimberley region of Western Australia. Consequently, its shares hadn’t moved despite a buoyant nickel price. It recently raised emergency capital to keep the Macquarie creditors from its door. Independence swooped. Name a big cap taken over recently? I can name three or four small caps.

SomnoMed, like so many small caps, is undergoing a turnaround, this one due to some serious strategic missteps. Hence it was cheap. The med-tech is also part of an industry going through a secular growth trend — the treatment of sleep apnoea. It has been attempting to tap into this demand and has recently woken investors up through its success in the US.

Another medical stock I have mentioned often in this column is Medical Developments (MVP), producer of the famed Green Whistle (emergency pain relief analgesic). This company is tapping into demand from around the world for affordable non-opiate-based analgesic pain relief.

Then there is ship builder Austal (ASB). Its earnings are less correlated with the market because of its 20 year-plus purchase cycle. It is unlikely to be affected by month-to-month variations in consumer demand.

The ASX is very concentrated from a market capitalisation perspective. Investors have great opportunities to look at its long tail in order to diversify their portfolios and gain access to stocks that move independently from the BHPs and NABs of this world.

Oh, and the next time I’m told about risky small caps I might offer them the Green Whistle.

Richard Hemming is an independent analyst who edits [email protected]