Australian fund managers are adopting a more positive mindset towards small companies, with a recent survey by asset consultant JANA, suggesting professional investors expect to find more opportunities in the sector than in big companies. 

Nearly two thirds of managers, view the outlook for small capitalisation stocks as “above average”, versus “average” for Australian equities as a whole, according to the survey.

The shift has coincided with an improved outlook for the earnings generated by small caps relative to companies within the S&P/ASX 100; a trend which first took root in February this year. JANA analysts argue this positive sentiment is likely to provide support for prices of small cap companies in the medium term as active managers allocate capital to the sector. 

The attitude towards bigger companies, also showed up in the survey respondents’ general underweight position to the banks and miners, which dominate the index and their overweight positions in the consumer staples, health care and industrial sectors which comprise a smaller part of it. 

Select pockets 

No one is predicting a bull market in small caps but there could be more opportunities in a sector which has traditionally proved difficult to navigate. Recent Morningstar research shows the S&P/ASX Small Ordinaries has generally delivered lower returns with more risk than the S&P/ASX 200, despite the wide-held expectation that small caps can deliver out-sized gains. 

“The probability of excess returns from the S&P/ASX Small Ordinaries relative to the S&P/ASX 200 is less than 50% using rolling periods of one to 10 years,” says Callan Maclennan from Morningstar’s manager research team. 

Nonetheless, he notes there are pockets of opportunity to generate the type of gains generally associated with this market segment. 

“It is clear that there isn’t a persistent small-cap premium when looking at index returns over long time periods; though, on a mean-reversion basis, you can see periods of outperformance in the short term,” he says. 

Fund manager VanEck, an Exchange Traded Fund (ETFs) provider, concurs with the respondents in JANA’s survey that one of those periods is potentially in the offing. 

“With inflation receding and interest rates stabilising, we could see small caps primed for a comeback,” says Russel Chesler, VanEck’s Head of Investments and Capital Markets. 

“Recently, we have seen more institutions expressing interest in the sector and an increase in corporate activity in the space. Take, for example, the Future Fund which earlier this year revealed it was investing in Australian small caps for the first time,” Chesler says. 

Passive or active? 

The question for advisers is how to negotiate the sector to cherry pick the stocks that will perform best and the time period in which they will do it. Both JANA and Morningstar are believers that active management is the best approach for those who choose to bypass this difficulty with a managed fund. 

“At the benchmark level,it seems that in Australia, good things in small packages is just a cliché,” say Mclennan when arguing against a passive approach. 

Chesler also makes the case for prudent stock selection in a sector that is not subject to the same widespread research as large caps. 

“The universe is littered with unprofitable companies and balance sheets are likely to come under the microscope as debt secured during the low interest rate environment rolls off,” he says. 

“Applying a dividend-payers screen is one way to seek higher exposure to companies that have lower financial leverage, higher return on equity and earnings stability, akin to the quality factor.” 

JANA says most Australian small cap managers in the eVestment universe have delivered strong outperformance (gross of fees and taxes) relative to their benchmark index. eVestment is an institutional investment data provider. 

“For investors with a dedicated allocation to small caps, the alpha that most managers have generated over the past three years would have offset some of the underperformance from a beta perspective between ASX100 vs ASX Small Ords,” Jana says. 

ETF options 

There are nine small cap ETFs listed on the ASX, split between active and passive managers. The largest is Vanguard’s passive MSCI Australian Small Companies ETF (ASX:VSO). Betashare’s Australian Ex-20 Portfolio Diversifier ETF (ASX:EX20) tracks the 180 largest ASX stocks outside the top 20 companies. 

VanEck’s Small Companies Masters ETF (ASX:MVS) holds 78 stocks and adopts a quality tilt. Quality investing is a defensive strategy that typically outperforms when economic conditions weaken or during times of heightened market volatility, Chesler says. 

This ETF returned 1.61% for the six months to September 30, outperforming the S&P/ASX Small Ordinaries Index by 4.08%. The biggest contributors to its gains in 2023 include AUB Group with a 32.14% year-to-date return, G.U.D Holdings (60.84%) and Smartgroup Corporation (73.02%). 

JANA expects the headwinds facing Australia’s largest companies to continue, with major bank margins under pressure from forces that do not impact small cap financials such as wealth managers and platform operators. 

Likewise, major miners may be impacted by falling commodity prices as global growth slows but smaller miners have more diverse revenue and are more exposed to materials like copper and lithium that will fuel the transition to net zero. 

If the above dynamics play out as expected, it may be that small caps will enter a period in which they can add value to overall portfolio returns.