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How Aussie small caps shifted from volatility to market darling

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4 minute read

Over the past decade, there has been significant change in the Australian small caps landscape, from the quality of stock composition to the impact of the emergence of a robust technology sector.

For Phillip Hudak, co-portfolio manager of the Australian Small Companies Fund at Maple-Brown Abbott, the Australian small caps market is at the forefront of innovation, offering a playground for uncovering future mainstream successes.

But it didn’t always used to be this way, said Hudak, on the most recent episode of the Relative Return podcast.

“First of all, the quality of the stock composition has really changed with the number of IPOs over the last 10 years that have been more capital, like models with a higher percentage of intangibles versus tangibles from what we’ve seen in the past,” Hudak explained.

“And we’ve seen the emergence of an information technology sector that has been born out at the smaller end of the market, is now growing at the larger end of the market as these companies become bigger.”

Another marker of change and a shift towards higher quality has been the upsurge in the number of companies with positive earnings.

“The other thing that we’ve also noticed is the proportion of companies that have positive earnings. At the EPS line, this has increased from 65 per cent in 2013 to now be close to 85 per cent today,” said Hudak.

“The other element is balance sheets are in a lot better shape than what we’ve seen in previous cycles. The return on equity of the Australian small caps market is now sort of looking at double digits versus the 10-year average which has been roughly about 7 per cent.

“And the real reason for that there is the greater percentage of companies that have positive earnings, lower debt load and as well as less exposure to those speculative binary-type companies, including exploration and biotech companies.”

Turning to the growing appeal of Australian small caps, Hudak explained that inefficiencies and information advantages present in small caps provide a fertile ground for generating alpha, a feat increasingly challenging in other asset classes due to technological advancements and AI.

“Australian small caps have the potential to deliver stronger capital appreciation versus many other asset classes. And this will be important to meet the financial goals of many investors out there, particularly if we are in an environment where returns may be lower than what we’ve seen over the past 10 or 20 years,” Hudak explained.

Moreover, he highlighted the condensing pool of market segments fertile for an active manager, noting that Australian small caps are a standout in this area.

Finally, he alluded to the ability of Aussie small caps to offer exposure to high growth potential.

“So, where are you going to find the next Afterpay? It’s going to be pretty hard to find that at the larger end of the market. But having a small caps exposure, you get the ability to get exposure there.

“From a cyclical point of view, it’s always challenging to find the bottom in markets there. But what I would say is, the earnings expectations of Australian small caps versus large caps going into the next couple of years is higher.”

Hudak acknowledged the past 24 months have been challenging for the Australian small caps market, but asserted the opportunities currently present in the market are unlike anything seen since the global financial crisis.

To hear more from Hudak, click here.

Maja Garaca Djurdjevic

Maja Garaca Djurdjevic

Maja's career in journalism spans well over a decade across finance, business and politics. Now an experienced editor and reporter across all elements of the financial services sector, prior to joining Momentum Media, Maja reported for several established news outlets in Southeast Europe, scrutinising key processes in post-conflict societies.