25 February 2016
To properly diversify in Australian stocks, it is necessary to look outside the largest stocks. Julian Beaumont, Investment Director at BAEP, discusses.
Not many major world stock markets are as concentrated as Australia’s. By market value, the local market is dominated by a small number of large stocks which have a disproportionate influence on our stock market’s performance.
At present, the top 20 stocks account for approximately 60% of the total value of the market. This means that Australian stock market investors have, on average, 60% of their investment in a group of behemoths that include the big four banks, Telstra and BHP. How their portfolios perform is largely determined by these top 20 stocks.
The appeal of the top 20
There are some good reasons for investors’ heavy exposure to the top 20 stocks.
Many take comfort in owning these large, mature ‘blue chips’ and may not be familiar with the opportunities beyond the top 20.
Others find favour in the attractive yields they typically offer, particularly in our current low interest rate environment. Previously, investors sought yield through term deposits; nowadays, many do so through investing in the banks themselves, which provide higher yields through juicy dividends. Consensus broker estimates indicate the big four banks offer an average prospective fully franked dividend yield in excess of 6%. Grossed up for franking credits, the banks yield closer to 9%.
Regardless of the reasons, many investors have funnelled their investment into the top 20, and as a result have a portfolio over-exposed to Australian banking, with maybe resources and telecommunications representing the extent of their diversification.
Professional investors call this ‘concentration risk’. In simple terms, this is often just a case of holding too much in the bank stocks. Professional investors such as fund managers face continual scrutiny over their relative performance, that is to say, their performance against the market index. This inevitably influences them to hold the largest stocks of the index itself. If it is a small group of large stocks driving index performance, as is the case in the Australian market, fund managers take considerable risk in deciding not to own them.
Retail investors don't have to worry about this. In this sense, they have an advantage over professional investors in being able to ignore the index. One should aim to invest in stocks that make the most sense, regardless of their size, and which provide genuine portfolio diversification. Diversification, through building a balanced portfolio, is the most prudent strategy to protect and build wealth over the long term.
Looking outside the top 20 stocks
To properly diversify in Australian stocks, it is necessary to get out of the top 20. Doing so will enable you to find a much wider range of sectors in which to invest.
Only among the ex-20 stocks will you find sectors such as infrastructure (which include exposure to airports, toll roads and ports), technology, food and beverage, specialty retailers and professional services.
Even for sectors represented in the top 20, the choice among the ex-20 stocks is far greater, allowing investors to very specifically refine their exposures. For example, there is just one healthcare company in the top 20 – the global bio-pharmaceutical giant CSL, which a global success story and now has a market valuation of approximately $50 billion. Among the ex-20 stocks however, there are a number of healthcare companies ranging from similarly mature companies (e.g. Ramsay Health Care which operates private hospitals) to early stage bio-techs who could quite conceivably become the next CSL in time. Like ex-20 stocks generally, some of these are profitable companies paying fully franked dividends; some are fast growing companies on the cusp of profitability; and some are yet to unfurl their potential. New and different opportunities are coming up all the time, with most new initial public offerings, or IPOs, being in the smaller end of the market. Many stocks also offer the kind of long-term share price growth that large-cap companies struggle to show, because they are relatively mature companies operating in relatively mature industries.
Ex-20 stocks also tend to be less correlated to macro-economic drivers. Whereas banks depend on credit cycles and resources companies depend on global commodity prices, smaller companies tend to be more in control of their own destiny. Their performance on the stock market will depend less on the latest economic data point coming out of China or the RBA, and more on the corporate strategy pursued, the success of new products or entry into a new market.
Winning with research
It is at this level of the stock market that market concentration works for you: with most of the investment flowing into the top stocks, so too does most of the research. In fact, there is a surprising level of investor ignorance of the stocks outside the top 20. This information gap in the market means that a dedicated specialist investor can find the kind of opportunities that simply cannot be found in large, well known stocks.
There is a stock-picker’s paradise outside the top 20: if you can take the time to explore the smaller cap stocks, and carefully select a few of the better opportunities, the long-term returns can be spectacular if you get it right. At the start of 2000, for example, Ramsay Health Care traded for $1 per share. It now changes hands for more than $60.
Specialist managers do the work for you
Of course investing outside the apparent safety of the ‘blue chip’ stocks can go badly wrong, too. They can be illiquid at times, and are usually more volatile than the larger-cap stocks. But it only needs one or two success stories to give you very good investment returns.
Being a riskier sector than the large-caps, there is a good case for using a specialist fund manager when it comes to investing in ex-20 stocks. There is a thriving population of such specialist funds, with their fund managers spending their time researching the stocks thoroughly, putting together a diversified portfolio, and monitoring their every moves. Investors effectively back the investment skill of the fund manager. Doing this well is often considered to be as much an art as it is a science, and the best managers do it very well.
The majority of the value in the ASX is accounted for by just 20 stocks. This disproportionate representation can create a number of risks. While investors are justified in seeking out the opportunities and diversification on offer beyond the top 20, it can be an intimidatingly expansive space. Considerable skill and effort are essential.
An ex-20 Australian equities strategy presents a compelling proposition for investors and not surprisingly, is attracting a growing investor audience. It offers a complementary alternative to the more traditional managed funds, harnessing the potential that lies within the broader market but outside the top 20.
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