A boutique fund manager has said that the recent underperformance of Australian small caps, relative to their larger counterparts, is likely to reverse, positioning this asset class as a compelling opportunity for investors “right now”.
In its latest research, Prime Value Asset Management said that over the past three years, small caps have underperformed large caps by approximately 10 per cent annually – a level of disparity last seen between 2013 and 2015.
Citing data from Morningstar, Prime Value said that Australian small-cap managers experienced net retail outflows totalling $2.6 billion over the past three years, reflecting investor hesitancy amid the sector’s struggles.
This underperformance has been attributed to two major headwinds: the broad impact of rising interest rates, which disproportionately affected small caps and a relative decline in earnings performance compared to large caps. However, both challenges are now expected to pivot into tailwinds, potentially fueling a resurgence for small caps.
“Given the reasons for small cap underperformance in recent years, the likelihood that this reverses, as well as small cap valuation support versus history, we see a current opportunity to allocate to high quality Australian small caps,” the report said.
Historically, equities have tended to rise during periods of declining interest rates, barring times of severe economic recession. According to the paper, small-cap companies are particularly well-positioned to outperform their larger counterparts in such environments.
The paper highlighted several factors underpinning the strong relationship between falling interest rates and small-cap outperformance, suggesting favourable conditions ahead for this segment of the market.
The first factor is lower borrowing costs, as smaller businesses tend to rely more heavily on external financing and are more sensitive to variable interest rates. Declining interest rates typically enhance smaller companies’ access to debt markets, reducing their financial constraints and supporting growth opportunities.
Secondly, lower interest rates enhance the present value of future earnings, making small-cap companies – often early-stage and growth-oriented – more attractive to investors. Additionally, their agility allows them to capitalise on reduced borrowing costs and favourable economic conditions faster than larger, more bureaucratic firms.
Superior earnings growth
Prime Value said that small-cap earnings growth is historically more sensitive to even modest market share gains, which have a greater impact compared to large caps. Additionally, small caps often operate in niche industries, providing greater operational diversity and unique growth opportunities.
“This typically sees small cap companies growing earnings more strongly than large caps in favourable market conditions, and conversely suffering greater earnings declines in weaker market conditions,” according to the paper.
Prime Value analysed small caps over the last decade, splitting the period into the “pre-Covid years” (2013–19) and the “Covid-years” (2019–23). The analysis found that the earnings (EPS) growth of small-cap stocks outperformed large caps in the pre-COVID-19 years and underperformed in COVID-19 years.
“Equity markets look forwards, however, and consensus estimates once again forecast stronger EPS growth for small caps relative to large caps over the medium term as the economy normalises post-Covid,” Prime Value said.
Separately, Australian small caps offer greater diversification compared to large caps and small-cap managers consistently generate alpha, according to the paper.
Smaller companies also provide the opportunity to invest across a wider spectrum of the economy.
“A key argument for investing in small caps is the success active Small Cap managers have had in generating consistent alpha,” the report said.
“This is a function of the relative inefficiencies in the small cap market, such as lower liquidity and less analyst coverage, combined with stronger earnings growth and a more fragmented index composition.”
Managers can also differentiate their performance from the index via portfolio construction, as the dispersion of returns remains much wider in small-cap stocks.
“While there are high-growth companies that deliver outsized returns, there are also companies that significantly underperform or fail altogether,” it said.
