Australian small-cap stocks are staging a rebound as investors rotate back toward long-term structural growth themes, including AI and digital infrastructure, the energy transition and critical minerals, as attention shifts away from near-term economic uncertainty.
The ASX Small Ordinaries index has struggled in the first half of this year, down by 240 per cent since the start of the year, but has risen again in the past month with welcome gains of 143 per cent.
SG Hiscock co-portfolio manager Phillip Li, says the rebound is occurring against a backdrop of elevated inflation, higher interest rates and ongoing market volatility, which has created a more selective investment environment.
“Despite persistent macroeconomic challenges, we are seeing investors increasingly reward high-quality businesses with strong competitive positions that are concurrently exposed to powerful long-term themes.”
Li is the co-portfolio manager of the $139 million SGH Australian Small Companies Fund.
He believes that, beyond short-term volatility, themes such as AI infrastructure, electrification and critical mineral security will continue to shape investment opportunities over the coming decade.
While AI has so far been framed largely around software and semiconductor innovation, the next wave of growth is increasingly centred on the physical infrastructure required to support it with the opportunity set extending well beyond data centres.
“Infrastructure investment platform Infratil was one of our strongest contributors, supported by growing confidence in the expansion of domestic data centre capacity required to meet rising demand from AI and cloud computing.
“Its exposure to CDC Data Centres highlights the accelerating investment required to build the digital infrastructure underpinning the AI economy”, said Li.
At the same time, the increasing adoption of advanced technologies continues to highlight the importance of securing reliable supplies of critical minerals.
“As governments and industries seek to diversify supply chains and reduce reliance on traditional sources of critical minerals, projects capable of delivering new supply are becoming increasingly important,” Li said.
The market backdrop has also been shaped by AI disruption fears and ongoing geopolitical uncertainty, which have pushed Australian small-cap valuations to near-decade lows.
While short-term sentiment remains driven by inflation, interest rates and broader economic uncertainty, Li said periods of volatility often create opportunities to identify businesses positioned to benefit from long-term structural shifts.
“Our focus remains on identifying these high-quality companies where our fundamental research indicates a meaningful disconnect between current market expectations and long-term value,” he said.
Broader market weakness has also created what ICE Investors describes as a compelling opportunity for long-term investors, despite continued strong underlying earnings growth.
ICE Investors managing director and portfolio manager Callum Burns says periods of broad market pessimism have historically created some of the most attractive entry points for patient investors.
“Markets have a habit of overreacting. We have seen it time and again through major events such as the Global Financial Crisis (GFC), COVID, and the small-cap dislocation of 2022,” said Burns.
“Every period of market stress comes with the belief that ‘this time is different’, but history consistently shows that indiscriminate selling can create opportunities for investors willing to look beyond short-term noise.”
Despite solid operational performance across many Australian small-cap companies, Burns said share prices have been heavily sold off as investors reprice risks tied to emerging technologies and geopolitical uncertainty.
“During reporting season earlier this year, most of our holdings met or exceeded expectations, and earnings growth remained strong. Yet valuations across many quality businesses have fallen to, or close to, decade lows,” he said.
“When high-quality companies continue to grow while their valuations compress sharply, history suggests markets eventually reconnect share prices with the underlying fundamentals. The recent takeover offer for one of our larger holdings, insurance broker Steadfast, is testament to this with offshore industry players initiating a takeover bid at a 50 per cent premium to the share price.”
According to Burns, concerns around AI disruption have become the dominant force shaping investor sentiment and are contributing to valuation disconnects.
“AI has the potential to be as transformational as the introduction of rail, reshaping industries and changing the way companies operate. However, the assumption that AI disruption will be immediate, universal and entirely negative is overly simplistic,” he said.
“Many businesses possess significant competitive advantages, including regulatory licences, established distribution networks, embedded customer relationships and decades of industry expertise. In many cases, AI can strengthen these businesses rather than replace them.”
Gaming company Light & Wonder and insurance broking group AUB Group are cited as examples of businesses that have experienced share price weakness despite maintaining strong competitive positions and long-term growth potential.
“The challenge for investors is separating businesses facing genuine structural disruption from those experiencing temporary valuation compression driven by market fear,” he said.
Burns said the current environment offers a compelling opportunity for investors willing to maintain a long-term perspective.
“Today, many investors are focused almost entirely on short-term uncertainty, but when we analyse the underlying businesses, we continue to see strong market positions, attractive growth prospects and valuations that imply unusually pessimistic assumptions.
“Cool heads rarely feel rewarded immediately, but over time, history suggests they often are,” he added.
