Why everything points to small caps outperformance this year
The stars are aligned for small cap stocks and history suggests they are about to lift — big time.
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 were concentrated among mega-cap technology companies including Meta, Amazon, Alphabet and Microsoft.
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 US Federal Reserve 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 US 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.
Roger Montgomery is founder and chief investment officer at Montgomery Investment Management
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