Flood of foreign cash headed into small-cap stocks

05 June 2015

The Sydney Morning Hearld, 5 June 2015

By Patrick Commins

In an attempt to limit the impact of foreign money flowing into our hot property market, the government may inadvertently trigger a flood of up to $3 billion a year into another arguably overvalued set of assets: small ASX-listed companies.

The catalyst is a change, effective July 1, to the list of eligible investments for foreigners to qualify for the significant investor visa (SIV). While the minimum amount of $5 million stays the same, the investment mix will shift from government bonds and residential property to a minimum 40 per cent weighting to high risk equity investments.

No less than $1.5 million will have to be invested in managed funds or listed investment companies that invest in ASX-listed emerging companies. Part of this requirement is that the managed fund must dedicate at least 80 per cent of its assets to firms with a market capitalisation of less than $500 million.

Of the remainder, at least $500,000 will have to be put in eligible Australian venture capital or private equity funds which invest in start-up and small private companies.

And what's left over – up to $3 million – can be invested in a combination of assets, including ASX listed companies, eligible Australian corporate bonds or notes, annuities and real property in Australia. The last is subject to a $300,000 limit on residential housing.

(There have been no changes to direct investing in residential property, which was never a compliant asset for SIV purposes and continues to be governed by the Foreign Investment Review Board.)

Given recent demand, Goldman Sachs equity strategist Matthew Ross estimates that up to 2000 of significant investor visas could be taken up a year. That would equate to annual capital inflows of $10 billion, of which about $3 billion would be invested in those ASX-listed "emerging companies". That's equivalent to around 30 days of small-cap trading volume, Ross says.

Likely boost to venture capital market

It could also boost the size of Australia's venture capital market by a multiple of nine, he calculates.

The change in rules comes at a time when there are already more, and bigger, fish swimming at the shallow end of the ASX pool.

"We've clearly noticed the big super funds have significantly increased their mandates with small- and mid-cap managers at the expense of [large cap funds]," Ross says. "It continues the trend we've seen for  a number of years now."

Ross reckons between 12 and 15 per cent of industry funds' investments in Australian equities is with small-cap managers, when the segment only makes up about 8 per cent of the ASX 300 by market capitalisation.

And a lot of those funds have come out of the biggest listed names.

"Most large-cap managers I speak to are structurally underweight the top 20 stocks, and then overweight the mid caps and small caps," Ross says.

Part of the explanation of that shift is structural – big industry funds recognise that the average large-cap fund manager struggles to beat its benchmark, and so, with an eye on costs as well as performance, have increasingly preferred a passive exposure in this space. Small-cap managers, on the other hand, have outperformed handsomely, and so have grown their funds under management.

Cyclical aspect

The other aspect is cyclical: blue chips just haven't been performing of late.

"There's a growing awareness that some of the oligopoly structures in Australia are under pressure," Ross says, pointing to the big supermarket owners and the banks.

"If you're trying to get double digit earnings growth in the Aussie market, you are almost constrained to be underweight the large cap stocks."

Since March, the average small-cap industrial stock has added 5 per cent, while the average share prices of equivalent businesses in the top 50 have dropped 5 per cent.

All of this has pushed small-cap valuations to extremes, says Ross. He calculates that the 50 stocks just outside the top 200 are trading about 40 per cent above their long-term averages.

"It's not surprising that [smaller listed companies] are trading at higher multiples than they have historically, but I would characterise [valuations] as being very stretched at this point."

(For the record, the smaller stocks Goldmans is "most constructive" on, says Ross, are OzForex, Covermore and SAI Global.)

Which brings us back to the potential $3 billion of foreign cash that may be headed into this already overvalued small-cap market in the space of a year alone.

There are only 110 companies in the ASX Small Ordinaries index with a market capitalisation of less than $500 million – which, you'll remember, is the upper limit under the new SIV rules – and they add up to a bit over a quarter of the total value of the index. Ross wonders whether there is enough "manufacturing capability for an influx of 'emerging company' money".

He does think that the new rules could have a "surprisingly large market impact", by which he presumably means already stretched valuations could be stretched further.

As is ever the case with shifting government policy, particularly in such a politicised space, investors need to watch out for unintended consequences.

Twelve months from now we could be talking about a "small cap bubble".

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