The sector is also expected to benefit from better earnings forecasts, trends towards onshoring and defence-related exposures, increased corporate activity and election uncertainty, according to fund manager Maple-Brown Abbott.
“In summary, we have been underwhelmed with the performance of the Australian small caps market relative to their larger counterpart given the number of tailwinds as risk appetite returns to the space after a few challenging years,” said Phillip Hudak, Maple-Brown Abbott’s co-portfolio manager for Australian small companies.
“We believe 2025 has all the hallmarks of being ‘the year of the Australian small caps’.”
The December data showed that the S&P/ASX Small Ordinaries Index returned 6.3 per cent in 2024, compared with 10.3 per cent for the S&P/ASX 100 Index, which was supported by the banking sector and strong momentum in high growth industrial stocks, and that the Australian small capitalisation market performance was mediocre in 2024.
It was driven by a “select group of high-quality companies” that grew earnings faster than underlying economic growth, the co-portfolio manager noted.
“This has been driven by market share gains via product innovation, market penetration and/or offshore expansion,” Hudak said.
Despite this, the sector was supported by small gold miners – now representing 12 per cent of the index weight – who benefited from gold being one the best performing asset classes in 2024.
According to Hudak, key stock beneficiaries included Genesis Minerals and Perseus Mining, which exceeded production growth targets and met cost guidance as labour pressures eased.
The year ahead
With the US equity market showing small caps started to outperform large caps in the second half of 2024, following Fed’s interest rate cuts, Hudak believes it sets a precedent for “what may happen domestically in 2025”.
“Domestically, the RBA has been uncoordinated with other central banks, remaining more hawkish given stickier inflation, although the December meeting has recast a more dovish tone with interest rate cuts expected to start early in 2025 with the market factoring in close to 0.75 per cent reduction by year-end,” he said.
“Given a more favourable domestic macroeconomic backdrop, we expect a better earnings outlook at the smaller end of the market (relative to large caps) over the next couple of years, resulting in a broadening out of stock performance across the index.”
Structural growth opportunities remain strong, particularly for IT-exposed companies that continue to deliver earnings despite many being priced for perfection, he added.
Contrary to 2023 and 2024, Hudak no longer expects an “earnings scarcity” premium, as investors may pivot to under-appreciated Australian small caps with stronger earnings outlooks and more attractive valuation metrics.
The manager also highlighted that a post-COVID-19 trend towards onshoring is providing a tailwind for small caps as companies seek greater supply chain security.
Moreover, heightened geopolitical tensions and deglobalisation are also driving global defence spending, which Hudak expects to escalate under a Trump presidency.
Election uncertainty will add another layer of complexity while supporting some sectors and Hudak believes continued fiscal spending and cost-of-living measures may be beneficial to aged care and childcare sectors.
However, he cautioned, investors will monitor the potential for a minority government and a potential change in government, and its implications for equity markets during the first half of the year.
Finally, the Australian small cap sector is expected to benefit from increased corporate activity.
Hudak highlighted some of the examples of merger and acquisition activity that already occurred in 2024, such as Chemist Warehouse’s “back-door listing” via Sigma Healthcare.
Commenting on expectations for 2025, he added: “Given the lower Australian dollar, improving earnings outlook and attractive valuations on offer, we expect increased M&A interest from offshore players for growing domestic small and nimble businesses.”
