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Why everything points to small caps outperforming this year

Why everything points to small caps outperforming this year

Since May last year I have been advocating for investors to consider smaller companies, locally and globally.   

The initial arguments rested on Gavekal Research’s empirical evidence in the late 1970s which said innovative companies with pricing power (of which there is a surfeit among small caps) do well when disinflation (which we see today) meets with positive economic growth (which we also see today). 

The combination of disinflation and a growing economy is not the only argument favouring small cap stocks, and there are a number of additional compelling reasons which suggest an allocation to small companies is sensible. 

The first is market concerns regarding interest rates, recession and earnings have changed. 

Previously, investors were confronted with rapid rate hikes, the pace of which were unprecedented for many newer market participants. Today, sentiment by both investors and central banks has shifted to the probability of rates having peaked, and possibly being cut later this year.  

Last year, lingering fears of recession dominated sentiment towards equities, with investors concentrating their bets on defensive stocks and companies. 

Even bets on artificial intelligence (AI) were concentrated among mega-cap technology companies including Meta (NASDAQ:META), Amazon (NASDAQ:AMZN), Alphabet (NASDAQ:GOOGL) and Microsoft (NASDAQ:MSFT). 

Today, the anticipation of a recession has given way to expectations of a soft landing, a “near miss” if you will, which in turn has shifted expectations about central bank monetary policy settings. 

Meanwhile, when the issue was rising rates — and associated recession fears — investors were understandably concerned about corporate earnings. Those concerns have largely proven to be misplaced with earnings, particularly for higher quality businesses, proving resilient. 

The result is investors are shifting their portfolio positioning from one of caution, with high levels of cash, to one where judiciously picking individual companies amid a willingness to adopt some risk results in the deployment of cash. 

Some of this optimism may be based on the outlook for interest rates and what we know of the performance of various equity indices after the U.S. Federal Reserve (Fed) cuts rates. 

While the timing of the beginning of a rate cut cycle remains unknown, expectations suggest the latter half of this calendar year. 

Should rate cuts transpire they would add fuel to the argument suggesting small caps could outperform. 

According to Wilson Advisory, Australian small companies perform substantially better than large cap companies after the Fed’s first rate cut. 

Indeed, in the 12 months immediately following the Fed’s first rate cut, the ASX Small Ordinaries has, on average, gained 8.1 per cent. This compares to the All-Industrial Index, which has, on average, risen just 1.5 per cent in the 12 months after the Fed’s first rate cut. 

Globally, the story is even more compelling, with the U.S. Russell 2000 small cap index gaining, on average, 20.2 per cent in the year following the first rate cut. 

Interestingly, if we plot the small ordinaries against the ASX 100 and zero the two indices back to a decade ago, we discover the gap between performance of the large caps and small caps has widened to approximately 25 per cent, measuring the greatest relative underperformance of small cap stocks compared to large caps in a decade. 

While the large gap is interesting, on its own it does not explain why it should narrow or close in the future. For this to happen, and for small caps to outperform, you should at least be looking for faster earnings growth among small caps. On that score we appear to have some good news. 

According to FactSet data, at February 15, 2024, consensus expectations for ASX 100 large cap compounded earnings per share growth over the next two years is just 3.1 per cent per annum. For the small ordinaries, earnings are expected to grow 15.2 per cent per annum over the same period. 

It seems the underperformance highlighted here might indeed turn to outperformance even without an expansion of the price-to-earnings ratio, which for the ASX 100 sits at 16.7 times and for the small ordinaries sits marginally higher at 18.1 times. 

And according to Refinitiv and Wilson Advisory, investors compelled to invest in small companies may be encouraged by the performance of Australian small cap managers to invest in actively managed small cap funds rather than directly in small cap equities. 

Over the five years to January 31 the ASX Small Ordinaries Index grew 5.4 per cent. Meanwhile, the median Australian small cap manager generated 9 per cent and the top quartile manager generated 12.1 per cent. 

So, it seems, small caps have underperformed, are relatively reasonably priced, are expected to generate substantially higher earnings growth over the next two years, and investors can access the opportunity through managed funds knowing in the past few years, median and top quartile small cap managers have delivered better returns than the market. 

This article was first published in The Australian on 23 March 2024.  


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.

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