When British economist E.F. Schumacher published his ground-breaking book Small is Beautiful in 1973, Newsweek’s review said it was, “Nothing less than a full-scale assault on conventional economic wisdom.” While Schumacher’s argument about empowering people and making work available on a more human scale is not the direct subject of this article, I have always believed there are important advantages that relatively small investors have over large institutions. Schumacher faults economics for failing to consider the most appropriate scale for an activity, and the same principle applies to investing. There is no doubt that many fund managers feel they would perform better if they had less to manage.
Notwithstanding conventional wisdom to the contrary, bigger is not always better.
In this article, I will focus not on the small retail investor, but on the ‘mid-tier’, that group of family offices, wealthy high net worth individuals, and smaller funds that operates across many asset classes. There are thousands of professionals who go about their daily investing without much profile, but with some useful advantages over the big end of town.
Consider a boutique fund manager who sets up a new business with a relatively modest $200 million to manage. It’s a fresh start, no existing capital gains or losses to influence a trading decision, no worries about exceeding the 5% and 20% ownership thresholds imposed by the ASX, no moving the market filling large orders.
Typically, a fund manager will have portfolio limits such as:
- no more than 10% of the portfolio can be placed into any one stock
- the portfolio cannot own more than 20% of the issued capital of any one company.
Assume this new fund manager has an intimate knowledge of a small company with a market capitalisation of $100 million which he thinks is well undervalued. Under his investment criteria, he can buy $20 million of this company, which will make up a significant 10% of his entire portfolio.
Then assume this fund manager is successful and a year later he is managing $2 billion. If he discovers a similar investment, the $20 million he can invest in a similar-sized company is now a meaningless 1% of his portfolio. Even if he is correct and the company’s shares skyrocket, the effect on his entire portfolio will be tiny. Although he loves the success of his business and the fees he earns on his big portfolio, he no doubt laments the days when he could be more nimble.
The capitalisation of companies listed on the ASX is surprisingly concentrated. The top 10 companies comprise 63% of the ASX/S&P200, and the top 50 are over 80%. The 200th company on the ASX has a market capitalisation of only $144 million. While 200 companies seems a lot to choose from, there are 2,200 companies listed on the ASX.
So there’s the first issue. The big fund managers must invest in the big companies. They simply have too much money to invest, and placing $10 million with a small company is hardly worth the research effort. Furthermore, larger funds are often ‘open-ended’, which means they are subject to new applications and redemptions. This requires the fund to remain liquid, and the most liquid stocks are the largest. Not surprisingly, since that’s where most of the activity is, it’s also where the most broker research is targeted. Large fund managers reward brokers with orders based on the quality of their research. Not much use spending expensive analyst resources researching a $50 million company if your clients can’t buy it.
Investment markets are comprised of many participants with unique circumstances, mandates and restrictions. Smaller investors should consider where they have advantages which should be arbitraged to the fullest extent possible, including:
- They can be genuine long term investors. Consider the predicament facing large fund managers during the GFC. As investors panicked, securities such as the listed hybrids issued by major Australian banks were sold off heavily, discounted as much as 40% below their issue prices. Frustratingly for many fund managers, knowing this represented excellent value for such quality issuers, they were not only unable to buy, but were also themselves forced sellers as their investors lodged redemption notices. A private investor can simply sit out these periods of turmoil and concentrate on the original ‘hold to maturity’ decision.
- A large portion of the Australian sharemarket is influenced by investors who are offshore or who are measured by pre-tax results. Both these factors mean that franking credits are undervalued. However, most large fund managers cannot take advantage of delivering after-tax efficiency to their clients, because their performance is not measured accordingly. In fact, they can appear to have underperformed pre-tax even if they have done well post-tax. For example, a large fund manager has no incentive to hold a stock for longer than 12 months to collect the capital gains discount, and indeed, may sell after 11 months without realising the impact on the tax bill of the end investor.
- Most professional fund managers manage their portfolios against specific benchmarks. Many are loath to be too different from these benchmarks lest they get the call wrong (even in the short term) and suffer the possibility of loss of business or loss of job. Smaller, private investors do not have this constraint and the investment portfolio can truly be managed in the best interests of the beneficiaries.
- Compared to retail investors, family offices and smaller funds are of sufficient size to negotiate lower agency costs (e.g. stockbroker fees, portfolio management fees, etc.), though they will not have the buying power of the large institutional investors and will obviously incur higher fees than them unless they leverage off a bigger relationship elsewhere.
- Most large managers need to value their portfolios to market regularly, as often as daily, as they have underlying investors coming and going from their funds. This continuous ‘marked to market’ environment means they are not naturally ‘patient investors’ and may avoid various illiquid investments, leaving such securities undervalued for other investors.
- There is considerable flexibility to buy and sell parcels of securities at short notice and with minimal effect on prices. Outside of the Top 50 companies, it is common for bid/offer prices on the ASX to be wide or subject to small volumes. A large investor can take days or weeks to buy or sell a stock, long after the more nimble have moved on.
It must be acknowledged, however, that larger investors do have their own advantages. The obvious ones are access to research and management. Sit in the foyer of any large fund manager at company report time and a steady stream of the highest profile CEOs in the land will parade through with their assistants in tow (whether this is of any value under the strict compliance guidelines of continuous market disclosure is another matter).
More tangible is access to major company placements, where a broker is given a mandate by a company to raise a chunk of cash quickly, usually at a discount to market, and the calls go out to the big managers. A good example is the large placement by Wesfarmers to Capital Research Global Investors ($500 million) and Colonial First State ($400 million) in February 2009 following the company’s $18.2 billion purchase of Coles in 2007. The acquisition left the company exposed to the GFC and high borrowing costs, and a worried market sent its shares down 50% from around $30 to below $15. The two big funds stepped up at $14.25 a share, while smaller investors had to be satisfied with a 3 for 7 pro-rata entitlement offer. Wesfarmers’ shares rose rapidly afterwards based on an improved balance sheet, and the large fund managers and their clients were handsomely rewarded.
And in the last 12 months, it is the large cap companies which have performed the best, as investors have sought the reliable income from their dividends in the face of falling interest rates. In fact, the ASX20 is only about 10% below its all-time peak, while the ASX200 is still 25% below. Many small companies are still 50% off their pre-GFC levels, so the large funds have not suffered recently from their constrained investment universe.
The conventional wisdom sees the Italian suits in the expensive high-rise offices, supported by teams of analysts and banks of Bloomberg screens, and assumes that’s where the action is. Meanwhile, in a small family office in a warehouse in the Inner West, a couple of casually-dressed guys are moving in and out of opportunities the large fund managers don’t even hear about.
Small can be beautiful, even if the suits can also do well throwing their weight around.