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Australian small cap stocks have witnessed some difficult years since 2021, with the woes intensifying between 2022-23. They are defined as stocks listed on the Australian Securities Exchange (ASX) with a market capitalisation between $50 and $500 mn. According to a recent report, there are over 2,000 companies listed on the ASX and most of them are Small Cap companies.
The benchmark is called the S&P/ASX Small Ordinaries Index, comprising 197 stocks as of January 31, 2024. In the calendar year 2022, S&P/ASX Small Ordinaries recorded a price return of -20.72%, marking the worst drawdown in the benchmark’s history. However, the index recovered in 2023, recording a price return of 4.71%.
In comparison, the S&P/ASX 100 which measures the 100 largest index-eligible stocks listed on the ASX, saw a 7.96% gain in 2023 and -3.95% in 2022.
Companies in Australia were hard hit by the rapid rise in interest rates and inflation during 2022 as they failed to pass on the rising costs to the customers due to low pricing power.
Simon Shields, co-founder of Monash Investors, an Australian equities investment manager, in an article for the ASX stated, “Small-cap stocks are less liquid than large-cap stocks. In times of uncertainty, there is a flight to liquidity, which tends to reduce the demand by investors for smaller stocks.”
On the other hand, JANA Investment Advisers points out that the underperformance is because of the low-quality companies in the small cap segment with dismal cash flows and balance sheet management.
Macroeconomic backdrop and valuations to support rebound
However, investor sentiment started to pick up in the Australian small cap space by the end of last year. As per Phillip Hudak, co-portfolio manager, Australian small companies at Sydney-based boutique fund manager Maple-BrownAbbott, “Australian small caps market is at an inflection point given the more favourable macro-economic backdrop and expected earnings trajectory. We believe we are seeing one of the most favourable environments for the Australian small caps market to outperform in 2024 since the global financial crisis.”
One of the biggest reasons why asset managers are upbeat about Australian small caps is due to their attractive valuation. Perpetual Asset Management believes that since the small caps significantly underperformed for more than 18 months, they are poised for a ‘revert’. The Australian asset manager argues that the changing interest rate environment is also enhancing the appeal of value investing.
“Valuations in small and micro-caps have been crunched – and typically, when you’ve seen such significant underperformance, it could be a good time to allocate to small caps,” Alex Patten, Co-Portfolio Manager Smaller Companies at Perpetual suggests.
Technology and mining sectors to see gains
From a sector perspective, Maple-BrownAbbott draws focus on the Australian small cap technology sector. William Hanna, Investment Analyst, Australian Small Companies at the boutique firm argues that the sector is driven by fundamentals and medium-term earnings growth.
“We believe the evolution of the technology sector to deliver more reliable quality earnings will continue to offer up exciting share price growth opportunities,” predicts Hanna.
Meanwhile, JANA Investment Advisers is upbeat on small cap mining stocks. Andrew Holmes-Galloway, Senior Analyst at JANA pointed out that while the larger miners face the headwind of falling commodity prices, the small cap miners are more diversified as they deal more with ‘transition’ materials like copper, gold, and lithium which are poised to see long term structural demand in electric vehicles.
Recovery in Australian small caps could be delayed
Investing in small cap stocks in Australia is not without downsides. Firstly, the expected rebound in Australian small caps could be delayed due to inflationary headwinds in the country. “If inflation was to start tracking up again, forcing a rise in interest rates by the Reserve Bank to dampen the economy, the recovery in small cap stocks would at the very least be delayed,” warns Monash Investors’ Shields.
Secondly, First Sentier points out that small-cap companies in Australia are substantially smaller than the global ones. Moreover, most small cap firms are not in the growth stage but at an early or introductory stage of the life cycle.
“.. Australian small caps are potentially more likely to be unprofitable firms, firms with no free cash flows, or firms that do not pay dividends. In other words, they may be riskier firms that underperform the broad market,” Wang Chun Wei, Portfolio Manager at First Sentier Investors cautioned.
Besides, Wang also expressed concerns about the lack of sector diversification and a high concentration of materials & mining stocks in the Australian small cap space.
