For financial advisers and professional investors only – not for distribution to retail investors.
April 15, 2024
By Derek Bilney
Australian small-caps significantly underperformed in 2022 and 2023 due to rising interest rates and expensive valuations. With solid returns in the past six months, we believe the opportunities for small-caps remain attractive due to:
- A likelihood that interest rates have peaked, supporting valuations and cushioning downside risk.
- High levels of takeover activity suggesting confidence in the longer-term market outlook.
- Rebounding risk appetite across a range of speculative asset classes attracting investors back into higher risk asset classes.
- The attractive earnings growth profile of small-cap companies.
Background
For most of the past decade, the performance of large-caps (top 100) and small-caps (ex-100) have generally tracked each other closely. This relationship broke down in 2022 and 2023, with large-caps outperforming small-caps by 19% and 5% respectively. As highlighted in Figure 1, there are tentative signs that this gap is starting to narrow with small-caps starting 2024 solidly, outperforming large-caps by around 2%, however, we believe there is scope for further reversion.
Figure 1: Large-cap vs Small-cap: closing the gap?
Source: UBS 2024
What were the drivers of the divergence in 2022 and 2023?
Two connected drivers: over-valuation and rising interest rates. Over-valuation was prominent in the more speculative end of the small-cap market in late 2021, particularly in early-stage, loss-making transition metals companies (lithium/nickel/graphic/cobalt etc) and IT/fintech companies that had rebounded sharply post-COVID. Future cashflows are worth less as interest rates rise and speculative growth companies were sold off. The end of ‘free money’ saw investors pivot towards cheaper, profitable businesses more resilient to changing economic conditions. This environment favoured large-caps over small-caps.
Why invest in small-caps now?
Economic backdrop
The economic backdrop is improving for small-cap companies. Official interest rates have likely peaked with scope to fall if the economy slows dramatically. Small-cap companies tend to underperform as an economy slows but outperform as economies bottom out and begin to recover. Arguably, we are getting closer to that point.
Earnings growth
Forecast earnings growth is higher for small-caps versus large-caps. Small-caps are expecting 20%+ earnings growth in FY25 versus 3%+ for large-caps. The earnings growth for small-caps is exaggerated by high growth expectations for resources companies, with earnings dependent on commodity prices and production levels. However, growth for non-resources companies remains solid at ~15%+1.
M&A is booming
Elevated levels of takeover activity in the small-cap segment are a positive sign for investors. Private equity and industry competitors have been lobbing takeover bids for companies across a range of industries at healthy premiums to closing prices. Motivations vary: appealing valuations, accelerating earnings growth, building scale, capturing synergies, mopping-up minority shareholders - but regardless it sends a positive message that potential acquirers are confident on the economic direction and believe current valuations are reasonable.
Examples of small-cap companies receiving bids in recent months include: CSR (CSR), Alumina (AWC), Perpetual (PPT), Sigma Pharmaceuticals (SIG), Boral (BLD), Red 5 (RED), Ad Bri (ABC), Link Administration (LNK), MMA Offshore (MRM) and APM Human Services (APM). As a bonus, most takeover proceeds will likely be reinvested back into the market.
Risk appetite is returning
No argument - small-caps are inherently riskier than large-caps and when risk appetite dries up, small and micro-cap companies can underperform. However, higher risk potentially leads to higher returns and there is increasing evidence that risk appetite is returning to the market. This can be seen in the improved performance of small-cap and micro-cap benchmarks and the performance of speculative assets such as bitcoin and gold which are at record highs. M&A activity is also a positive indication of risk appetite.
Our approach to investing in small-caps
A risk of small-cap investing is falling for the narrative – the story – rather than considering the underlying investment fundamentals. This is an example of narrative fallacy – a common investor bias. One way to avoid falling foul of narrative fallacy is to look for good quality companies with appealing valuations.
The Macquarie Systematic Investments stock selection model uses approximately 65 company metrics (ie ‘signals’) to identify and rank investment opportunities in the small companies space. These investment signals encompass a range of different investment styles, including Value, Quality, Sentiment, Growth and Volatility, as well as signals that provide orthogonal information to these standard styles.
This results in a well-rounded view of each stock in the investment universe. Proprietary tools are then used to construct robust, diversified portfolios that are designed to outperform across a range of different investment conditions – aiming to deliver consistent alpha to investors.
Author
1 Source: Factset
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