Another advisor suggests small caps
Recently, Wilsons Advisory released a report outlining their case for small caps. At the risk of repeating what we have already said over the last twelve or so months, investors keen to allocate capital to an opportunity to potentially boost returns, will be interested in the small cap bull case from a third party.
Our argument (admittedly preferred since late 2022) for investing in small caps is based on three observations:
- Since the 1970s, innovative growth companies with pricing power (quality) have done well when disinflation is accompanied by positive economic growth. No recession in 2023, despite contrary predictions, along with continuing disinflation, should see those innovative companies (of which there is a surfeit in small caps) do well and,
- In 2023, the supportive backdrop noted in the above point coincided with stellar performances by innovative growth companies with pricing power. But thanks to ongoing fears of a recession in 2023 (ultimately without foundation), surging stock prices were confined to innovative mega caps with pricing power and,
- The gap in performance between the mega caps and innovative small caps renders the latter relatively affordable. The supportive ‘disinflation + economic growth’ backdrop remains in situ, providing a stage for quality small caps to ‘catch up’ to their large cap peers.
I recently stated that I believe stocks will do well into 2026 in my “how to maximise returns in 2024 and beyond” blog post, and given the underperformance of small caps, they should provide a much-needed boost to returns through outperformance.
Wilsons Advisory begins by observing that small cap stocks have indeed begun to outperform their larger counterparts, reversing recent underperformance. They also note historically, small caps tend to lag large caps as economies approach a slowdown. This has certainly been the case with the marked underperformance of small caps since 2021.
Wilsons Advisory believes the fourth quarter of 2023, however, marked a pivot for small caps amid stronger expectations of a soft economic landing (positive economic growth, noted in bullet point 1 above and diminishing inflationary pressures (disinflation, noted in bullet point 1 above). Wilsons Advisory adds that the expectations stage is set for interest rate reductions later in the year and for economic growth to reaccelerate, strengthening the case for small cap stocks to shine.
Value
Wilsons Advisory points out that despite their recent uptick in performance, small cap stocks remain significantly undervalued compared to their larger counterparts, boasting a discount that hasn’t been this appealing in more than two decades. They highlight that historically, when small caps have been this deeply discounted, they’ve tended to follow up with robust returns over the next year, especially in environments where macroeconomic and policy conditions become favourable.
Supportive economics
Wilsons Advisory further observes that traditionally, small cap stocks have shown superior performance to large caps during the initial or expansion phases of the economic cycle. Small caps have historically been attractively priced just as the global business cycle embarks on a new phase of expansion, and Wilsons Advisory cites 2003, 2009, and 2020 as key examples. These years marked significant milestones where small cap stocks not only performed strongly in absolute terms but also relative to large caps. Particularly in 2003 and 2009, this strong performance heralded the beginning of several years of sustained outperformance.
Wilsons Advisory concludes that although risks exist of a lagged impact of tighter monetary policy and risk associated with a higher-for-longer interest rate scenario, these fears might be outweighed by encouraging signs of a soft-landing in Australia, the U.S. and global economies.
Australian small cap managers outperform
The final point Wilsons Advisory makes, and it’s one we have made here many times, is that “the domestic small cap median manager has a well-established track record of outperforming the small cap benchmark by a considerable margin. Indeed, the domestic small cap median manager has marginally outperformed its large cap peer over the past 10 years.”
At Montgomery Investment Management, we believe the stage is set for small caps to outshine again. Paraphrasing Wilsons Advisory’s paper, an appropriate allocation of one’s portfolio to a small cap manager (and we would suggest reviewing the merits of the Montgomery Small Companies Fund) amid “the prospect of a stronger period for the small cap benchmark would be the icing on the cake for the asset class. Small cap sweet spots can lead to very strong return phases when combined with ongoing active manager alpha”.
In other words, small cap managers tend to beat their benchmark, but it really helps when the stage is set for that benchmark to do well.
Learn more about the Montgomery Small Companies Fund here.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
