Over the past few years, the dominant driver of performance for the Australian sharemarket has been large cap companies, particularly the likes of CBA.
More recently, however, market leadership appears to have shifted to companies sitting outside of the top 20. The mid and small cap segment are outperforming large caps, after years of underwhelming returns
A major catalyst for this shift in market leadership is RBA’s switch to an easing bias in monetary policy. The RBA’s move to cut the cash rate to below 4% this year has created conditions that are more favourable to mid and small cap companies. Historically, these market segments have outperformed during previous rate cutting cycles, as lower borrowing costs tend to benefit businesses that are still scaling their operations and that are reliant on external capital to fund growth.
From 2015 through to the COVID-19 period, when the RBA maintained an easing bias, mid and small caps significantly outperformed their large cap counterparts. That relative strength, however, reversed during the recent tightening cycle, as higher funding costs and inflationary pressures squeezed margins for smaller businesses. However, once more since the start of the year, as rates have continued to come down, the performance gap has started to close again.
The red hot Q3 quarterly CPI inflation print ruled a line through a further RBA cut in November, but Governor Bullock’s subsequent commentary made it clear that future rate decisions are a choice between whether to cut or pause, so it is clear that an easing bias remains. In any case, the lower level of interest rates may be as important as the rate of change, as lower rates reduce the debt burden of mid and small cap companies. In addition, if future rate cuts are delayed by persistent inflation from stronger economic growth, such an environment can help economically sensitive smaller companies grow their top line revenue.
In fact, earnings fundamentals are already turning in favour of smaller companies. Recent reporting seasons have shown mid and small caps are delivering stronger earnings growth than large caps, helped by lower input costs and improved cash flow. This strong earnings growth is expected to continue for mid and small caps, thanks in part to the larger weight towards sectors like Information Technology and Industrials, and a lower reliance on Financials, a sector largely expected to face slower growth in the years ahead.
Yet despite the improving earnings outlook, the Small Ords Index still trades around a 20% discount the S&P/ASX 100 Index valuation after years of underperformance.
If these trends hold, mid and small caps could offer not only a cyclical buying opportunity at a very attractive entry point, but also sustainable, long-term growth as market leadership shifts towards this end of the market.
Mid-caps represent a ‘sweet spot’ as they are usually well-established businesses, but not so large that they have exhausted all their potential growth opportunities. Although it is important to note that identifying which companies will succeed, and which will not, can be difficult and even professional money managers don’t always get it right. According to recent data from S&P, most active managers in the Australian mid/small cap category have failed to consistently outperform their benchmarks over time, with very few maintaining top-quartile performance across multiple years.
Small caps also offer investors the potential for higher growth, though of course this is paired with greater risk and volatility. These businesses tend to be more sensitive to interest rates and economic cycles and can benefit materially from lower funding costs. But the small cap universe can also be crowded with speculative miners and early-stage companies with weak fundamentals, so it’s important to avoid the temptation to try make concentrated bets on these companies.
When it comes to allocating to small caps, investors should consider tilting exposure toward small cap companies with positive earnings, strong balance sheets, and solid momentum. By focussing on quality metrics, investors can reduce exposure to financial underperformers while still capturing upside potential. Over time, strategies that apply these kinds of screens have historically tended to deliver more reliable and consistent returns compared to traditional small cap benchmarks, particularly during periods of market stress.
Many investors have shunned Australian mid and small mid cap stocks after five years of underperformance, but those poor returns can be explained in large part by interest rates that jack knifed higher in 2022 and have remained elevated until earlier this year. As the Australian equity market looks set to enter a new phase of market leadership in terms of performance, investors should consider rebalancing their portfolio in line with this shift. Investors and their financial advisers can use the ever-growing range of ETFs as tools to upweight their exposure to small and mid-cap parts of the market. For example, both EX20 and SMLL, upweight Australian equity exposure to the mid and small cap parts of the market.
In any case, investors should always maintain portfolio diversification across global and Australian growth and defensive assets to take advantage of what may be the only free lunch in finance. A robust multi-asset portfolio is the best way to both safeguard against and capitalise on shifting market narratives, with ETFs offering an increasing array of tools to improve performance in line with investor views.
