Home / Equities / ‘Tide has turned’: Small cap opportunity never clearer, especially in Australia

Inflation has likely peaked and the small cap market has bottomed out. The bad news is that relative returns have already started improving. The good news is that we're still a few standard deviations from the mean, and there's still plenty of upside.

The evidence that small caps have reached their valuation nadir and are on the cusp of an upswing is compelling, according to sector analysts, with both global and domestic economic indicators pointing to a resurgence after what has been a torrid few years.

Large-caps and mega-caps have dominated stock exchanges in Australia and the US respectively in the past few years, with the ubiquitous ‘Magnificent Seven’ tech companies increased their global dominance while banks, mining companies and supermarkets maintained their hold on the top end of the ASX. Meanwhile, an inflationary economic environment and attendant high interest rates buffeted capital allocation to small and mid-cap companies.

With inflation off the boil, however, and central banks forecasting that stabilised interest rates will now begin to fall before the end of the year, now could be a savvy time to take advantage of depressed pricing in the small-cap sector.

“The space has really underperformed over the last couple of years due to a lot of macro headwinds, but many of those headwinds are looking to be neutralized and potentially become tailwinds,” said Chris Chen from American Century Investments (pictured) on stage at The Inside Network’s Equities and Growth Assets Symposium in Sydney, who said small caps are would provide a “great antidote” to market concentration. “If you ask me, the stars are aligning,” he added.

Market concentration at the top end of both indices is a “real” risk, Chen said, regardless of how enamoured investors are with the companies lead the market. “Historically, we’ve seen that high levels of concentration have marked or signaled the peak of these large cap cycles.”

The shift to lower inflation will not only mean more capital gets allocated to small and mid-caps, explained Invesco’s Scott Bennett, but it should result in a broad increase in risk tolerance across the investment landscape – especially in the domestic market. “We have a much more stable economic backdrop and we’re actually seeing our risk levels from investors increase,” he said.

For investors, small cap allocations are staying attractive because they are “still below trend”, Tully added, with central banks here and abroad maintaining dovish sentiment to keep a lid on inflation. “There’s obviously a significant valuation discount.”

That discount won’t last forever, however. According to Ausbil portfolio manager Andrew Peros, “the tide is turning” for small caps, and the “divergence of performance” between large and small caps is starting to narrow after reaching its nadir in October 2023.

“My view and the Ausbil view is that rates have peaked and inflation has peaked, so with that the small cap market has bottomed,” he said, adding that there is good news and bad news in that for investors. “The bad news is relative returns in small caps have started to improve since the fourth quarter of last year, so if you have zero allocation to small caps, you’ve missed the bottom. The good news is that we’re still two standard deviations below the long-term mean so there’s still plenty more upside.”

As to where the individual pockets of opportunity lay, Yarra Capital’s Dion Hershan noted that while the big tech stocks in the US dominate headlines, the domestic tech market is rife with opportunity on the small-cap end of the spectrum.

“We’re often enamored with global tech, but we actually have some genuinely fantastic Australian tech businesses,” he said, using PEXA, Seek and carsales.com as examples. “Tech has maybe only two and a half percent of the ASX 200, but it’s very well represented once you get outside the 20, and although we don’t have hundreds of tech names to pick from, we’ve got a few dozen and from that comes some pretty core positions for us.”