Why it might be time for small caps to shine

There are promising opportunities arising in the typically volatile small caps sector as broader conditions show initial signs of improvement, indicating it might be time for small caps to shine. 

Compared to other stocks in the last 18 months, small caps have been more heavily affected by interest rate hikes, inflationary pressure and a weakening economy, particularly in their difficulty in passing on costs. 

It is currently witnessing a decade-high valuation gap from large caps as at the third quarter of 2023.

However, looking ahead, it feels like small caps are getting into a good spot, according to Liam Donohue, portfolio manager for the Lennox Small Companies Fund and the Lennox Microcap Fund.

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Speaking on a recent Ensombl Investment Podcast, he said: “It definitely feels like small caps are in a good spot after a tough few years and that definitely lines up with some of the emerging themes or trends we’re starting to see in the small cap market, typically trends like technology advancement and even things like artificial intelligence which are popular in the moment, [it’s] where those trends typically present first, so it is quite exciting to see that happening now.

“I guess one area to look at is that small caps typically trade ahead of where the markets think the cycle is heading. We usually see small caps sold off when the market is expecting any sort of economic slowdown and then small caps typically bottom when either things start to look a bit better or at least people get comfortable that things aren’t getting any worse. 

“That’s definitely what we’ve seen this cycle with small caps’ extended periods of underperformance versus large caps, but what that does feel like now is that some of the leading economic indicators we’re seeing have levelled out, and at some point, that means they’re going to get better in relative terms, and small caps will absolutely move along with that or possibly even ahead of that, given that equity investors tend to be probably perpetual optimists.”

While a bit of a nervous call to make, Donohue contended it “might be time for small caps to shine”. 

Going by J.P. Morgan Asset Management’s monthly market review for October, small caps posted a 5.5 per cent decline even as 10 of 11 sectors were in the red. Meanwhile, the ASX 200 had another poor month after a negative September, falling 3.8 per cent.

Although utilities managed to stage a rally of some 1.7 per cent, the firm noted the worst performers were in IT (-7.6 per cent), healthcare (-7.2 per cent), industrials (-6.4 per cent) and real estate (-6.1 per cent). 

Simon Brown, co-portfolio manager of the Tribeca Smaller Companies Strategy, contended that small caps have performed poorly across the past 18 months, but there remains room for growth.  

Appearing on Money Management’s Relative Return podcast, he explained: “Small caps have historically struggled during hiking cycles, this one more so than recent history.

“[They] tend to be more cyclical. The make-up of the small cap market, particularly this time, is overweight some of the more cyclical parts of the economy. If you think about that, it’s discretionary consumer exposed, building materials, technology, non-bank financials, all areas which are going to become more challenged as the cost of debt goes up and liquidity is retrenched.”

Meanwhile, large caps get some offshore earnings exposure that can support its performance, particularly when the currency depreciates, he noted.

“The small end of the market is more volatile – we argue to counterbalance that, you tend to find more interesting growth opportunities and it grows faster,” Brown said.

“I don’t think there’s anything structural that’s happened in the current cycle to say to us the small cap opportunity is diminished.”

He also flagged the return of migration in the domestic economy for potential growth, adding: “There’s going to have to be capacity added across the economy to handle an influx of additional people and a larger population. We think that should largely support domestic growth as we come out the other side of this cycle and into a better period of growth going forward.”

As market conditions improve, Brown said the fund is conscious of new opportunities in consumer-facing areas in which it has been underweight post the pandemic-induced spending sprees. 

Other areas of interest include materials, such as lithium and the less popular green steel; legacy oil and gas names; and recent gains stemming from uranium.

He added: “Even in technology, which has come under a bit of pressure lately, we think there are some names that are reasonably, fairly valued with good forecast growth ahead, potentially ahead of what markets are expecting or pricing stocks for at the moment.”