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Are Australian small caps poised for a renaissance?

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By Rhea Nath
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4 minute read

Portfolio managers are optimistic that small caps will make a resurgence in the next 12 months, citing excellent buying opportunities in the market.

While Australian small caps might have faced a volatile few years in the market, two portfolio managers have opined that the tides could be turning.

Since 2021, Australian small caps have been disproportionately affected by an aggressive rate hike cycle aimed at taming inflation, hurting particularly those with significant debt and growth goals. Over the calendar year 2022 and up to 30 August 2023, they suffered a 19 per cent decrease on a price basis.

As at 6 February 2024, however, the S&P/ASX Small Ordinaries Index has demonstrated an upward swing, standing at a -0.03 per cent price return year-to-date.

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According to Ausbil’s Andrew Peros, 2024 could mark the perfect time to revisit small cap allocations.

Appearing on the Relative Return podcast, the portfolio manager explained: “We are super excited about Aussie small caps in 2024.”

“Part of the reason for the excitement is because we’re coming off the back of a two-year drawdown in the broader small cap market. You recall that central banks were attempting to tame inflation with one of the fastest rate hike cycles in history, which evidently was a burden for small caps. Not only for those companies that were heavily indebted, but also rising rates meant that small caps were disproportionately underperforming the broader part of the market,” Mr Peros explained.

“Small caps are typically associated with the growthier type of the market, and in a risk-off environment, they tend to suffer the most.”

Turning to historical data, Mr Peros observed that small caps have had a tendency to outperform large caps when an easing cycle has commenced.

“The scenario that we’re seeing here at Ausbil in the small-cap team is very similar to what we saw in the mid-90s, when the Reserve Bank of Australia raised rates three successive times in 1994. Inflation was an issue there, and as always, there was this fear of an economic slowdown and risk of a hard landing that didn’t eventuate. And then small cap started to take-off,” he explained.

“As the market got confidence that the worst-case scenario was unlikely to play out, small cap started to rally. Then the RBA cut rates and that really fuelled the next leg of outperformance for small caps.”

Looking at relative returns in the small-cap universe, he declared that “small caps are back”.

“Relative to large caps on a three-year rolling basis, we’ve seen a material drawdown in small cap returns. In fact, small caps have underperformed large caps by about 40 per cent over the last two years. And that drawdown is something we haven’t seen in the past 20 years, not since the dot-com bubble.

“So we think we’re there at the bottom with a settling macroeconomic backdrop. That’s what we think we need to see, a renaissance in small caps,” he said.

Mr Peros shared that, regarding Ausbil’s investment philosophy, high-quality businesses with well-managed teams are on the firm’s radar.

“We have a strong bias towards founder-led businesses, looking for those companies where the founders have significant skin in the game, companies that are capital light, that have a high return on investor capital and can be self-funding through various cycles,” he added.

Richard Ivers, portfolio manager for the Prime Value Emerging Opportunities Fund, echoed the optimism for small caps this year.

“In small-cap stocks, there is well-placed optimism about the number of quality companies which are attractively valued. Many of these were oversold as the small-cap sector lagged large-cap stocks over the previous two years, creating excellent buying opportunities and an exceptional opportunity for long-term investment returns in quality small-cap companies,” he agreed.

He favours relatively defensive companies with a strong earnings growth outlook, stating “earnings resilience is an attractive characteristic over the longer term” in such stocks.

However, Mr Ivers cautioned investors to keep an eye on managing potential volatility when it comes to this asset class.

“The smaller end of the market can be volatile but this can be tamed somewhat by focusing on the more quality companies, which demonstrate resilient earnings.

“It’s important to invest with an eye on volatility because even in bull markets the next challenge is never too far away. We are optimistic but also realistic about current geopolitical instability and the potential for inflation to be more stubborn than we would like,” he said.

Are Australian small caps poised for a renaissance?

Portfolio managers are optimistic that small caps will make a resurgence in the next 12 months, citing excellent buying opportunities in the market.

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