2024 is being touted as the year of the small cap. But why?

If I had a dollar for every time that a fund manager or financial expert has said that 2024 is going to be a big year for small-cap stocks, I'd have enough to set up a whole separate portfolio! This year has been consistently touted by stock market bulls as the year for small caps to make a big comeback, especially given how concentrated the rally has been in the mega and large-caps. 

And we've already seen some evidence of this - the Small Ordinaries Accumulation Index is up 23% since the end of October 2023.

Small caps have performed as monetary policy has shifted to an easing bias

But what are the fundamental reasons why this small-cap rally supposedly has legs? And what could potentially kill (or at least, impede) the rally before it's even started?

To find out, I sought the views of Ausbil Investment Management's Small and Micro Cap specialists - Arden Jennings and Andrew Peros.

Why this year is small cap investors' year

Jennings and Peros say there are two primary reasons - both macro-driven - which explain why small caps are due for a lasting rally this year.

"Firstly, global GDP activity is gradually improving and should ultimately lead to consensus earnings upgrades. This is akin to achieving a ‘soft economic landing’, setting the scene for a ‘soft take-off’ in corporate profits."

"Secondly, following an extended pause in global interest rates, we believe we are now on the cusp of a rate-cutting cycle as inflationary pressures, for the most part, appear to be under control," they said.

"Both of these factors will lead to a broadening of earnings growth across various rate-sensitive sectors, providing a welcome relief for Australian small caps," they added.

There is also a third, less-talked-about reason why small caps have been long overdue to have this rally - small cap share prices (on aggregate) are coming from secular lows. Or put another way, large caps have rallied so much that any unwind will likely see that cash moved into small caps instead. The chart below demonstrates this divergence in detail.

"This level of underperformance is similar to that seen during the 2015 European Debt Crisis, the GFC and the dot.com bust," Jennings and Peros noted.

The chart tells the story

We then challenged Jennings and Peros to furnish us with a unique chart that explains the story best. They went above and beyond, picking two charts that show the parallels between the early 1990s recession (the "one we had to have") and the current experience.

"The bulk of Australian small-cap underperformance materialised against the backdrop of rising debt costs and tighter liquidity conditions. This scenario is quite similar to the situation of the mid-1990s when the RBA raised interest rates three times to tame inflation following the recession of 1991," they said.

Rates and relative returns in the wake of the 1991 recession

But now that rates have stopped rising (and are likely to remain that way), small cap returns are rising in anticipation for what comes next.

"The observations of the mid-1990s are relevant to the current environment, albeit that rate cuts are expected while the economy is still growing. With this background, we expect small-cap performance relative to large caps to accelerate when consensus finally accepts a soft economic landing," Jennings and Peros added.

Small-cap returns tend to move inversely to interest rates

What can prove this base case wrong?

One word: Inflation.

"We think that the key risk is the prospect that inflation remains stubbornly high, pushing out the timing and quantum of rate cuts. At the beginning of 2024, the consensus was expecting 7 cuts in the USA and 3 cuts in Australia. Both economies have proven to be incredibly resilient, and inflation particularly stubborn, and now the consensus is only expecting 3 cuts in the USA and 2 cuts in Australia," Jennings and Peros noted.

"Equity market valuations are still factoring multiple rate cuts into their outlook, so to the extent that rate cut expectations are pared back, there remains an element of risk to current market levels," they added.

3 ASX small caps Ausbil would buy today

To finish this piece off, we asked the Ausbil team for three companies they would be happy to buy today over a 3 to 5-year time horizon. 

• Aussie Broadband (ASX: ABB): We believe founder-led Aussie Broadband is the next emerging Australian telco provider, and it is a top-10 holding in both the Ausbil MicroCap and SmallCap strategies. 

In our view, investment in its own network infrastructure, further expansion into the business, enterprise and government market segments, and growing demand for high-speed internet connectivity all support the outlook for continued growth for years to come. 

Following an upgraded guidance statement at the 1H24 result, the ABB share price recently retraced on a proposed but rejected merger between ABB and Superloop (ASX: SLC), with SLC securing the Origin contract from ABB at the same time. We see significant strategic merit and synergies in a combined entity with the potential to become the third largest NBN broadband player in Australia, ahead of Optus. 

We expect any potential deal will benefit shareholders of both companies. Regardless of any potential merger, we believe ABB offers significant valuation support with a robust balance sheet to support strong future earnings growth.

• Megaport (ASX: MP1) is a global leading network-as-a-service provider that enables its customers to rapidly connect their network to other services such as data centres and cloud service providers already connected on the Megaport Fabric. 

Recently appointed CEO Michael Reid has joined the firm from CISCO after 15 years. As the uptake of the cloud grows, enterprises are increasingly using multiple cloud service providers to create best-of-breed, multi-cloud and hybrid cloud solutions to solve business IT challenges. Traditionally, interconnections between the end-user and multiple providers were achieved by costly point-of-presence connections at each data centre. 

Megaport’s global platform solves this challenge by providing a scalable, flexible and secure cross-connection from the end-user to multiple cloud service providers. Megaport has service agreements with all major cloud providers and is expanding its industry-leading Software Defined Networking through installations in global data centres and cloud on-ramps. Networking effects mean that the business scales as the network expands, a real value proposition to new users and increasing barriers to entry for potential future competitors. 

MP1 has recently become cash flow positive, and we believe their annual recurring revenue and future growth will surprise on the upside in the next few years.

• Light & Wonder (ASX: LNW) is a gaming-based company with a leading market presence across land-based gaming (second largest market share), social casinos with a market rank of three, and iGaming in the US where they hold the number one position. 

A refreshed and reinvigorated management team in conjunction with asset sales resulted in a more focused and commercially-aligned business. We believe this should ensure that the company delivers above category growth, and share gains and remains the pioneer of new categories like iGaming. A greater commitment to R&D investment in new gaming content is expected to ensure the pipeline is full content to deliver future success across multiple channels. 

Financially, strong cash generation and a healthy balance sheet only add to its investment appeal. While the LNW share price performance has been strong over the past six months, we believe we are only just beginning to see the rewards following multiple years of hard work and investment under CEO, Matt Wilson. 

An EBITDA of $1.4 billion in FY25 was once considered a stretch target, however, it is now looming as a reality, and the focus now turns to what the company can achieve in the future.