Expectations that Australian small companies may be ready for a sustained rebound have gathered pace as professional investors eye the economic outlook.

Small capitalisation stocks (small caps) are considered by many analysts and investors to be one of the first asset classes to recover after a downturn. They are considered to be more nimble and easier to turn around than their large cap counterparts as economic conditions improve.

This is obviously reliant on economic conditions turning and especially interest rate rises halting. Some investors are less certain that rate rises are nearing their peak and that a recession can be avoided. 

That said, some advisers and their investors are getting ready – with a large sample of data from AUSIEX showing the net value of small caps trades is rising, up more than 15 per cent over the six months to the end of March 2023.

Those favouring small caps also point to the fact that more were sold off in the downturn than their larger counterparts – both here and overseas. In fact, the range of returns for Australian listed companies last year was among the widest seen in 20 years, according to Sean Freer, Director of Global Equity Indices at S&P Dow Jones Indices in Singapore.

The S&P/ASX 50 outperformed the S&P/ASX Small Ordinaries by 20.28% in 2022 as rising interest rates and energy costs impacted profit expectations. Large caps also outperformed the S&P/ASX MidCap 50 by 8.14%.

“Small caps are often the first to be removed from asset allocations in favour of large cap equities or more defensive assets,” said John Lockton, Head of Investment Strategy at Sandstone Insights. 

The underperformance accelerated as the Reserve Bank of Australia began increasing interest rates in May 2022 – and was then further compounded as notable larger small caps stocks were removed from the small-cap index. 

Now, following that underperformance, specialist small-cap investors suggest the outlook for the sector is brighter and that last year’s sell-off provides a number of investment opportunities.

Bell Asset Management says that small and mid-caps revenue growth and earnings growth is currently comparable to other growth asset classes, but with lower volatility. It suggests small and mid-cap companies (SMID caps) sit perfectly in a portfolio driven by quality at a reasonable price, style of investing.

As to whether global or Australian small caps are preferred, some analysis suggests that small caps also do better when the Australian economy is doing better.

Which small cap stocks?

MST’s Lockton noted the S&P/ASX Small Ordinaries has a significant skew to its top 10 stocks, which represent 60% of the market capitalisation of the index. 

“Excluding the travel-related stocks of Auckland International Airport (ASX:AIA) and Flight Centre (ASX:FLT), the average earnings growth this year is expected to be 15%, close to three times that of the broader market,” Lockton says.

“Looking further ahead, the 3-year compound annual growth rate of these stocks is expected to average 8%, again higher than the market.”

When will small caps close their relative underperformance? Lockton says it will likely be the peaking of interest rates – both official rates and long-term bond yields. 

“The small-cap index typically has more growth-oriented companies versus the large-cap index, so lower discount rates will help. It also has a greater percentage of domestic demand stories, so falling interest rates will likely help both the earnings and the earnings multiple.”

The much harder aspect to anticipate is a return to the ‘animal spirits’ which are ultimately needed to re-rate small cap underperformance. 

“A return of the bull market in growth and growth expectations would be a clear positive for the relative performance of the Small Ordinaries Index,” Lockton says.

Largest small caps stocks on the Australian Stock Exchange 

Source: Refinitiv, Datastream

Advisers should consider the objectives of their clients and how small caps could contribute to their portfolio, while meeting their risk tolerances - as with any investment, there can be risks. 

Exchange traded funds or ETFs can remove some of the downside by leaving stock selection to professionals.  

AUSIEX sampled a large cohort of its client data and found that the Vanguard MSCI Australian Small Companies Index ETF comprised the vast majority of trading during the six months from 1 October 2022 to 31 March 2023, accounting for almost 74 per cent of total traded value, according to AUSIEX.

Most traded small cap ETFs