Value.able: Roger Montgomery

By digging deeper, investors can tap into a neglected source of potential wealth

The Australian small companies market has the ability to generate significant wealth. This is, first, because stockbrokers don’t earn enough revenue from brokerage on small companies and therefore don’t research them, leaving them undiscovered and potentially cheap. Second, by fostering innovation, small companies provide investors with access to new business models, products and services on, or close to, the ground floor.

Small companies also provide a means of beating the market. That’s because a majority of active small company fund managers beat the index. By randomly selecting a small cap manager, investors have a better than 50% opportunity to outperform their passive-investing brethren. With a little due diligence the odds are bound to improve.

Small companies’ funds must remain small and nimble themselves to be able to invest and generate meaningful returns. Consequently, many are now closed to new investors. And it is potentially risky investing in smaller companies without the required experience and, particularly, the knowledge of management. The surest way to winnow the winners from the losers is to know the management intimately.

A little less than two-thirds of all stocks in the small cap index over the past decade have produced a negative average return, and only slightly more than a third have produced a positive return. In other words, for every Afterpay winner there are two Dick Smith disasters. Investors would be wise to rely only on reputable and experienced managers in the small cap sector.

I spoke to Gary Rollo and Dominic Rose, of the Montgomery Small Companies Fund, to find three small caps worthy of mention.