Well-diversified portfolios will likely have exposure to a wide range of assets, investment approaches and styles. Each piece of the investment puzzle adds up to creating stronger total portfolios with potentially better risk-adjusted returns than those based on a single thematic.
This informs our case for investing in stocks outside the S&P/ASX 20 (ASX 20).
ASX 20 stocks form the core of many investors’ Australian equity exposure. High-dividend yields with franking credits provided by some of the largest companies, such as the big four banks, Telstra, and Woolworths, for instance, are valued by many and this also contributes to many investors’ large-cap bias.
The dividend yield issue deserves a little more unpacking as it offers an important compare and contrast between large-cap investing and investing outside the ASX 20.
Large-cap stocks’ high-dividend yields often stem from the reality that mature companies generally have lower capital needs owing to their relatively lower growth potential than their mid-cap and smaller counterparts. Consequently, returning a lion’s share of earnings to shareholders through high-dividend yields is an obvious use of large-cap stocks’ capital. However, it can also become a trap for high-yielding companies. We have seen many instances of companies who have lost their entrepreneurial flair and destroyed long-term shareholder value by aiming to support their share price through consistently high dividends.
By contrast, mid-cap stocks – those outside the ASX 20 universe – are typically less mature and offer higher capital appreciation potential, but lower dividend yields than their large-cap counterparts. These companies generally have greater growth prospects than large-cap stocks and thus a greater share of earnings is reinvested for growth.
The argument for investing outside the ASX 20 (i.e. ASX ex-20) isn’t built on knocking large-cap investing. Rather, it’s an argument for complementary investing as mid-cap stocks offer different attributes to their large-cap counterparts.
The earnings trajectory test
Earnings per share (EPS) growth is the fuel that propels total returns. There is powerful evidence that mid-cap stocks, represented by the ASX ex-20 universe, occupy the long-term EPS sweet spot.
The strong EPS growth from the mid-cap segment stems from being rich with companies that have established themselves and deliver strong earnings, but which have not yet become mature companies. Moreover, mid-cap stocks often enjoy strong organic growth prospects that can be funded from earnings rather than needing additional equity capital from shareholders.
Mid-cap companies, as a group, still have attractive revenue growth runways ahead of them and unlike small caps, need less equity to grow. Disruptors able to grow both earnings and market share by remaking existing industries feature in the mid-cap market.
These factors result in the ability of the mid-cap market to compound EPS growth over the long-term. This is how the S&P ASX Mid Cap 50 has consistently delivered the strongest total returns for investors, exceeding the S&P ASX 200, S&P ASX 20 and S&P ASX Small Ordinaries.
Contrast that with Australia’s large-cap stocks. From a business life-cycle perspective, the large companies dominating share markets might not present the most rewarding investment opportunities.
As a group, they tend to be mature businesses that generate more cash than they can spend on future growth opportunities. When a company’s market share is already very large, the limit to growth is no longer just a theoretical concept. Consequently, their earnings growth trajectory is often a little lower.
Superior long-term EPS growth from the ASX ex-20 cohort has translated to higher total returns, above the ASX 200, ASX 20 and ASX Small Ordinaries. These findings indicate exposure beyond large cap stocks, to include mid-cap equities, can boost return potential.
A more even spread of sector weights in ASX ex-20
A quick glance at the ASX 200’s sector composition confirms what generations of investors have known – the Australian share market is very financials and materials (resources companies) dominated. It’s estimated the two sectors combined represent around 50 per cent of the broad Australian share market (as measured by the ASX 200) by market capitalisation.
What all this distils down to is that many equity investors’ financial wellbeing is effectively tied to two factors – the housing cycle, in the case of financials, and commodity price cycles, in the case of materials.
Additionally, housing cycle exposure embedded within the ASX 200 is magnified by the fact that most Australians’ largest asset is residential property. This “doubling-up” means that many investors unwittingly have outsized housing-related risks.
By expanding into the ASX ex-20 universe, where no sector overdominates, investors can diversify this concentration risk.
Wider return dispersion emphasises greater active management opportunity
The wide dispersion of returns in the ASX ex-20 universe, versus the ASX 20, emphasises the value of active management.
Over one year to 30 September 2020, there was almost a 225 per cent difference between the best and worst-performing ASX ex-20 stocks. Over three years to 30 September 2020, there was over 200 per cent difference between the best and worst-performing ASX ex-20 stocks.
By contrast, return differences between the best and worst-performing stocks in the ASX 20 were far narrower over the same periods. Just over 150 per cent for the year to 30 September 2020, and just 78 per cent for the three years to 30 September 2020.
In other words, picking the best-performing stocks in the ASX ex-20 universe provides potentially greater reward than stock picking in the ASX 20.
This is unsurprising as there is outsized sell-side analysts’ coverage of the ASX 20 compared to ASX ex-20 companies. It’s difficult for investors to gain information advantages on companies already receiving saturation coverage.
On the other hand, owing to lesser coverage, ASX ex-20 investors have far greater scope for stock picking on the back of proprietary research.
We end as we started. It’s not about pitting one asset class against another, or one investment approach against another.
It certainly doesn’t involve knocking investing in ASX 20 stocks versus other parts of the local share market, including the ASX ex-20 universe.
There are good arguments for investing in both. However, the long-term earnings power of companies in the ASX ex-20 universe, diversification attributes and greater opportunity for stock selection make it worthy of investors’ consideration.
John Guadagnuolo, portfolio manager, Antares Equities