PDA

View Full Version : Small Caps/Big Caps



Packersoldkidney
17-11-2004, 03:54 PM
Article in today's Sydney Morning Herald by Allan Kohler - worth a read if you have the time.

Betting big time on the small stocks
By Alan Kohler
November 17, 2004

The money pouring into hedge funds, the rise of boutique small cap fund managers, probably the growth of DIY super funds and even the apparent willingness today of a lot of GPT unit holders to bet that an auction will develop by voting against Lend Lease's scheme of arrangement, are all manifestations of the same thing: a global shift towards greater risk.

Underlying this are two powerful, related phenomena: a cyclical reduction in volatility and dispersion (the difference between the best and the worst); and the low inflation/low interest rate environment that makes double-digit investment returns hard to achieve.

Except in Australia, this year.

Usually, small companies are valued at a discount to big ones because they're inherently riskier. Over the long term the average discount is 20 per cent but, sometimes, when fear stalks the market, as in the mid-90s and after the 2000 tech bust, it blows out to as much as 40 per cent.

Right now in Australia the small cap discount is 4 per cent. The All Industrials price earnings ratio is 15.7 times while the Small Ordinaries average P/E is 15.1 times. Over the past six months the Small Ords has risen 24 per cent while the 20 Leaders has gone up 8 per cent.
AdvertisementAdvertisement

Pretty soon a dollar of earnings from a tiddler will, on average, cost more than a dollar of earnings from a giant company.

The powerful bull market in Australian small cap stocks over the past six months is part of a global trend driven by two powerful forces: the secular decline of the US dollar and the worldwide flight towards higher risk.

Even though US interest rates have doubled, the cost of American money is at an historic low. The US dollar is also overvalued and in decline.

Therefore the Australian currency is seen as a one-way bet and the economy is sound: basically the cost of speculating in Australia is zero at worst - if anything, currency gain has been more than paying for the cost of the money.

Underlying this is the increased appetite for risk. To some extent this is a characteristic of all bull markets and is underpinned by 14 years of economic growth and greater confidence after the re-election of the Howard Government.

Between July 1 and the election the average daily rise in the Small Ordinaries index was 2.8 points; since the election it has accelerated to 4.2 points per day.

But there's more to it. Expectations of double-digit investment returns were built up during the high-inflation 1980s and then reinforced during the internet bubble and property boom of the '90s.

In the past five years inflation has been subdued and equity and property returns have shrunk. The main exception to this has been the emergence of China as a driver of commodity prices, but exposure to commodities has not been sufficient, on its own, to maintain excess investment returns from balanced funds.

At the same time wealth management has become extremely competitive; short term performance tables are life and death.

To try to keep performance in double figures, fund managers are increasing their tracking error (versus the benchmark indices) by taking bigger bets on fewer companies.

Moreover, super fund trustees are shifting more and more money into hedge funds and boutique fund managers which specialise in small cap stocks. In many cases, individuals approaching retirement are setting up DIY funds to punt their super on speculative stocks to try to get their lump sums up.

Also, with global financial market volatility now very low - the US Vix index of volatility, for example, is at an eight-year low - the reported "value at risk" of banks and institutions can be reduced while the actual exposures are increased (VAR is basically the size of the position times volatility - if one goes down, the other can go up).

Outperformance of small cap stocks has been a worldwide phenomenon this year

Cooper
17-11-2004, 04:28 PM
Very good article POK... have been reading about the large Bank's VAR for about a year in The Economist. Worth thinking about (or acting on!)

Packersoldkidney
17-11-2004, 04:33 PM
Hi Cooper: what edition of the Economist is that?

Cooper
17-11-2004, 05:25 PM
"Too clever by half", Jan 22nd 2004,
"The coming storm for banks", Feb 19th 2004
Probably some other ones that I've flicked through and then forgotten too... generally in the "Finance and Economics section".
I did post something regarding this on an NZX thread on banks but it wasn't very intelligent and was promptly ignored. Justifiably so too, poor effort on my part.

Packersoldkidney
17-11-2004, 06:20 PM
You are too harsh on yourself. Thanks for the heads up - I'll track those articles down.

Cheers

Packers.

Cooper
23-03-2005, 08:00 AM
Kind of related to VAR... higher risk for a bank comes with higher interest rates... why I wouldn't be buying banking stocks at the moment (or getting involved in high return debentures!)




Banks warned over home loan risks
By Lisa Murray
March 23, 2005

Page Tools
Email to a friend Printer format
A slowdown in home lending is forcing banks to take on more risk to maintain their market share, the Reserve Bank of Australia has warned in its latest Financial Stability Review, released yesterday.

The RBA said that lending practices were "diverging some way from the tried-and-tested methods of the past", as "low-doc lending" was growing rapidly and more use was being made of mortgage brokers.

While this did not pose an immediate threat to the financial system, the RBA said it needed to be "closely watched".

"To the extent that these various changes are the outcome of a more competitive market they are to be welcomed, provided that lending institutions fully understand the risks involved and are pricing those risks appropriately," the RBA said in its biannual report.

"Whether or not this is the case will only be evident in a weaker economic environment."

The RBA warning comes just one day after National Australia Bank said it would start selling low-doc loans through its branch network.

Advertisement
AdvertisementWestpac has also recently stepped up its push into the low-doc market by offering more attractive interest rates. Regional banks have been selling low-doc loans for some time.

The RBA refers to one bank in the report, believed to be Adelaide Bank, for which low-doc loans account for nearly 30 per cent of outstanding housing loans.

Low-doc loans are typically designed for self-employed people with limited records of their income.

But the RBA said they "may also be sought by borrowers who have understated their income for tax purposes but wish to declare the correct, higher amount, to their lender, or those who are overstating their income for borrowing purposes.

"From a financial stability perspective, this latter category of borrower is the main source of concern, given that their capacity to service loans may be poor."

Low-doc loans are different from non-conforming loans, which are typically to borrowers with impaired credit histories. That market is dominated by specialist lenders such as Liberty Financial and Bluestone Mortgages.

Cooper
02-04-2005, 01:30 PM
Obviously, the fact that the RB of Aus is on top of this is a good thing, but it's still a worrying sign regarding the tendency of Banks to throw a little of the standard caution to the wind these days, in search of profit maximisation.

http://www.theage.com.au/news/Business/Lowdoc-loan-market-too-juicy-for-the-big-banks/2005/04/01/1112302233136.html?oneclick=true



My problem isn't that the Banks aren't operating honestly... I have no idea regarding Bank operations. My problem is that people are getting "easy money" without the banks checking that the money will be put towards viable projects. Therefore if there is a downturn then these loans may be in trouble. This will have consequences for both the Aus and NZ economies, and also for the shareholders of the banks themselves, should the loans be defaulted.

Edit: Sorry for hijacking your thread, POK.