Investors have shunned underperforming small cap Australian equities in recent years, but there is reason to believe the sector is about to turn the corner, says Activus Investment Advisors.
The largest 100 Australian listed companies have returned investors 11.74 per cent in the five years since 2012, leaving the S&P/ASC Small Ordinaries index in the shade (returning 4.17 per cent).
Activus Investment Advisors co-founder Robert Talevski said the "outperformance gap" of 7.57 per cent has been created by investors' appetite for higher yielding large cap stocks.
As a result of investors "piling into" large caps, small caps are now cheaper than large caps on a price-to-earnings basis, Mr Talevski said.
"Large caps with a price to earnings ratio 18.3 times are considered expensive relative to its long-term average and in comparison to small caps with a price to earning ratio of 16.1," he said.
"The estimated three-five year earnings per share growth rate of small caps (15.4 per cent) is well ahead of the large cap growth rate of 10.8 per cent," Mr Talevski said.
The strong earnings growth expectation for small caps along with their attractive price earnings measures are "supportive of performance for small caps going forward", he said.
More generally, it makes sense to increase exposure to small caps on an asset allocation basis, he said.
Small caps tend to offer considerable returns potential, diversification benefits, a stronger alignment between management and investors, and the ability to access new companies, Mr Talevski said.
"Being a long-term investor also helps allowing smaller companies to achieve their growth expectations over the long-term without being affected by short-term fluctuations," he said.
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