The smaller end of the Australian share market has experienced a resurgence as of late, as investors move away from blue-chip stocks like Commonwealth Bank of Australia (CBA) and CSL in search of more attractive valuations.
At the same time, some of the most high-profile small-cap darlings have recently been faced with negative attention.
In particular, the much-hyped counter-drone technology leader, DroneShield, came under hot water earlier this month after company founder Oleg Vornik and a group of directors sold almost $70 million worth of stock – sending shares plunging 30 per cent, with further revelations arising since then.
In a statement on 24 November, the firm reaffirmed its commitment to an independent review of its continuous disclosure and securities trading policies, as well as other areas, while reiterating its dedication to its core business.
DroneShield joins other small-cap standouts, like family-tracking app Life360 – which DNR Capital portfolio manager Sam Twidale highlighted last month as a top performer – in showing stellar returns for fund managers, before recently being flagged as significantly overvalued.
However, speaking to InvestorDaily, Emmanuel Datt, chief investment officer at Datt Capital, said that small-caps as a whole remain an attractive asset class.
“I believe the genuine upside is significant, as the valuation gap between Australian small-caps and large-caps remains historically wide and persistent.
“The sector is still under-owned and under-researched, creating a rich hunting ground for finding mispriced ‘blue chips of tomorrow’,” Datt said.
He added that the small-cap rebound appears to have further to go, likely marking the start of a “multi-year recovery phase” where the valuation gap is expected to narrow.
Datt’s stance is reflected among the allocations of some larger asset managers, with BlackRock recently cutting back on Australian large-cap exposure in favour of their smaller counterparts.
Last week, BlackRock informed investors that its Balanced Enhanced Strategic Model Portfolio has reduced exposure to Australian large-cap stocks, trimming its holding in the iShares Core S&P/ASX 200 exchange-traded fund (ETF) by 2.2 percentage points in its balanced portfolio and 2.7 points in its conservative fund.
Meanwhile, the firm has allocated 1 per cent to the iShares S&P/ASX Small Ordinaries ETF, with its moderate, growth, and aggressive portfolios also integrating the small-cap strategy.
According to Uwe Hulmes, BlackRock’s lead strategist, the move was motivated by more attractive small-cap valuations compared with large caps, improving sentiment indicators, and the opportunity for differentiated sector exposure.
Datt said the move represents a “massive validation” of the alpha potential of Australian small-caps.
“When global heavyweights and institutions begin allocating here, it confirms that the pricing inefficiencies and latent value in Australian emerging companies are becoming impossible to ignore.
“It signals a structural shift where smart money is moving to capitalise on the growth profile that most large caps cannot provide,” he told this publication.
Commenting on concerns about overvaluation, he said a pullback could be beneficial, clearing out speculative capital and giving investors the chance to back companies with solid structural growth and reasonable valuations.
“We view volatility not as a risk to be feared, but as a source of opportunity for active managers to acquire high-quality assets at discounted prices,” he said.
“Ultimately, market dislocations provide the attractive entry points necessary to generate outsized long-term alpha.”
Looking ahead, Datt said the firm remains bullish on small-caps, expecting them to “significantly outperform the broader index” as the valuation gap continues to normalise. He noted the firm is especially focused on companies poised to benefit from geopolitical trends, as well as technology firms capitalising on artificial intelligence (AI) adoption.
In addition, he concluded that a stabilising interest rate environment could further support risk appetite, favouring “agile companies” that can grow earnings regardless of the macro backdrop.
