Market pundits are forecasting a potential strong run for Australian small companies in 2025 as a result of anticipated earnings growth, attractive valuations and expectations that interest rates will fall at some point.

The S&P/ASX Small Ordinaries index generated a total return of 8.36% in 2024, compared to an 11.44% return from the S&P/ASX 200 index.

James Nguyen, Portfolio Manager at Tyndall Asset Management, argues the outlook remains positive as forecast earnings growth for small caps is double that of large caps for the next two years.

“At the same time, smalls are trading at a 10% discount to large caps,” Nguyen has written.

He says the discount is rarely this wide and that local small caps as a whole are in a relatively strong position, with balance sheets sitting in decent shape.

“Small caps are the biggest beneficiary of lower interest rates because they’re more correlated to the economic cycle, have lower pricing power, and less access to debt markets,” he adds.

In particular, the outlook may bode well for industrials and the consumer discretionary sector if the Reserve Bank of Australia begins to ease interest rates.

“We've observed an acceleration in retail sales growth to 3.4% per annum, and the potential for rate cuts this year could ignite a broader cyclical rally, which historically benefits these sectors,” says Cameron McCormack, Portfolio Manager at VanEck.

Competitive advantages

Morningstar has a similar view to others, arguing that many small companies may be lesser known but have strong competitive advantages.

“Opportunities are most abundant in smaller stocks – about 60% of our 4 and 5-star-rated stocks are outside the S&P/ASX 100 index,” the research firm says in its latest Australian Equity Market Outlook.

“Meanwhile, the large caps have run hard, and valuations look stretched. The S&P/ASX 20 has returned roughly 25% since mid-2023, but aggregate earnings fell modestly in fiscal 2024, and we only expect a low single-digit increase in fiscal 2025.” 

A caveat to the above forecasts is that small caps are more sensitive to changes in the economy compared to other companies. An unexpected deterioration in conditions – such as Australia or the US falling into a recession – would likely result in the underperformance of this part of the market relative to large caps. 

Rising geopolitical tensions and/or Australian dollar weakness would also spur market volatility that may adversely affect small caps – though many analysts appear to regard the likelihood of these risks disrupting the potential performance of small companies as relatively low.

ETFs to consider

Around half a dozen exchange traded funds allow advisers to add a diversified parcel of local small companies to clients’ holdings. The biggest by far is the $1.35 billion Vanguard MSCI Australian Small Companies Index ETF (ASX: VSO), which tracks the MSCI Australian Shares Small Cap Index. It generated a total return of 8.35% in calendar 2024 from stocks including data centre operator NextDC (ASX: NXT), gold company Evolution Mining (ASX: EVN) and JB Hi-Fi (ASX: JBH). 

Two other ETFs track the SPDR S&P/ASX Small Ordinaries Index – the iShares S&P/ASX Small Ordinaries ETF (ASX: ISO) and SPDR S&P/ASX Small Ordinaries Fund (ASX: SSO). Their top holdings include IT company Life360 (ASX: 360), Pinnacle Investment Management (ASX: PNI) and Zip Co (ASX: ZIP). 

The VanEck Small Companies Masters ETF (ASX: MVS) instead tracks the MarketGrader Australia Small Cap 60 Index. Its top 10 holdings also include Zip Co and Pinnacle Investment Management Group (ASX: PNI), as well as mining services company Perenti (ASX: PRN) and AMP (ASX: AMP). Its total return was 4.93% in the year to December 31 and 2.72% per annum in the five years to the same date.

Key attributes

Tyndall’s Nguyen argues that its critical to find quality small companies that compound earnings and buy them at a discount to their intrinsic value. One example he nominates is lottery ticket reseller Jumbo Interactive (ASX: JIN).

“They have cash on the balance sheet, fantastic margins and operate in an environment where online lottery sales continue to grow much faster than bricks and mortar or retail sales… Another [company] is SciDev, which has water treatment technology”. 

“Where we see material value that is underappreciated by the market is their technology which can treat hazardous man-made chemicals known as Perfluoroalkyl and Polyfluoroalkyl Substances (PFAS),” he says.

VanEck’s McCormack suggests HUB24 (ASX: HUB) is another company worth watching as a result of its success in capitalising on dramatic changes to the wealth management industry by expanding its range of platform, technology and data solutions.

“Over the last five years, the fintech’s share price has risen by 45% per annum, with the last 12 months seeing an increase of more than 100%,” he says.

VanEck also suggests the robust earnings and global footprint of jewellery retailer Lovisa (ASX: LOV) make it another company that could outperform.

“The Australian small cap universe differs from other developed markets as it has a higher proportion of unprofitable small cap companies in the ‘infant’ stage of the business cycle, particularly in the mining sector,” McCormack says.

“Our preference is to employ a growth at a reasonable price (GARP) strategy which selects stocks based on growth potential, value, profitability and cash flow across dozens of fundamentals. Sophisticated strategies have been shown to outperform the S&P/ASX Small Ordinaries index.”

Small caps may be poised to shine but typically offer a higher risk-return profile than large caps – so being selective in investments is more crucial than ever.

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