2024: The year of the small-cap?

After two years of underperformance, small company returns are starting to inflect
Matthew Fist

Firetrail Investments

The ASX Small Ordinaries Index underperformed the ASX 100 by over 20% over the last two years, which is typical in a period of rising interest rates and slowing economic growth. However, with worst fears of further interest rate hikes and economic meltdown now alleviating, investors are turning their attention back to small caps. The ASX Small Ords rose 14.8% in the last two months of 2023, compared with the ASX 100 return of 12.4%.

Looking forward, we believe 2024 could be a breakout year for Aussie small caps. Small caps deliver their best absolute and relative returns (versus large caps) coming out of slowdowns in economic growth. We don’t claim to have a crystal ball, but consensus economic forecasts predict the current economic slowdown will bottom and start to recover from Q2 2024.

The valuation and earnings backdrop strengthens our conviction that the outlook for small caps is strong. We explain why below.

A Porsche for the price of a Kia...

We see compelling value on offer in the small caps market today. The ASX Small Ordinaries Index is trading on a similar P/E ratio to the ASX 100, but is expected to grow earnings six times faster over the next 3 years!

There is significant opportunity for active managers to construct a portfolio even more compelling given the inefficiencies in the small cap market. The Firetrail Small Companies portfolio exhibits nearly double the earnings growth estimates than the ASX Small Ordinaries despite trading on a lower P/E multiple.

To illustrate with a stock example, today you can buy a high growth, defensive, founder-led business like Kelsian on 18x FY2024 earnings estimates, or you can buy Woolworths on 25x. Call us biased, but we know where we are putting our investment dollars!

Looking under the hood

The key question investors should be asking is: what is driving the superior small caps earnings outlook? Is it real? If so, what are the stocks and sectors I need to invest in to participate in this growth and potential return?

To answer these questions, we need to look under the hood of the small and large cap indices. As shown in Figure 3, the ASX 100 is dominated by the big banks and iron ore miners. Financials and Materials make up 55% of the index. These sectors are expected to grow earnings at less than 1% p.a. over the next three years, a huge drag on total index earnings growth.

On the other hand, the ASX Small Ordinaries (Figure 4) is more diverse and balanced across sectors. Each sector is contributing healthy earnings growth forecasts, with standout contributions from Materials (23%), Health Care (52%), and Technology (67%).

 

But are these earnings forecasts credible?

We are always cynical when it comes to forward earnings forecasts. In the past, bullish growth forecasts for concept stocks inflated index earnings estimates, leaving investors disappointed when the growth didn’t come through.

The Resources sector in recent years provides a case in point. The ‘EV materials bubble’ of 2022 saw spectacular growth expectations for stocks with the potential to supply critical decarbonisation materials, such as lithium, graphite and rare earths. Doing research on these companies revealed that many didn’t even have a viable resource. The bubble burst last year, with six of the Small Ords Index’ worst ten performers in 2023 being decarbonisation materials producers.

While we are sceptical of a select few companies contributing to today’s growth outlook, the difference between today and two years ago is stark. For the most part, the companies driving today’s expected earnings growth are high quality and sustainable. Tying back to the Resources example, investors are now more closely scrutinizing the underlying quality of resources assets, rather than simply buying a thematic trade. More realistic valuations provide the base for a constructive outlook in 2024.

Exposure to sectors with the strongest outlook is crucial

The key takeaway? If you want to participate in small caps’ superior earnings growth outlook, you need to have exposure to the Materials (i.e. Resources), Health Care, and Technology sectors. The Firetrail Small Companies Fund is modestly overweight these sectors, where we are finding compelling bottom-up opportunities.

We share some of our most exciting high conviction positions in Figure 5 below:

Conclusion

After two years of underperformance, the outlook for small companies now looks extremely attractive. History shows that small caps outperform following periods of slowing economic growth. With the current slowdown seemingly in its final innings, and valuations attractive relative to a strong growth outlook, we believe Aussie small caps are primed for significant outperformance over the coming years.

To access the growth on offer in small caps today, investors need to have exposure to the key sectors contributing to this growth, particularly Resources, Healthcare and Technology. 

At Firetrail, we are excited by the bottom-up opportunities on offer in these sectors, and the broader small cap market, today. 


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Firetrail Investments Pty Limited ABN 98 622 377 913 (‘Firetrail’), Corporate Authorised Representative (No. 1261372) of Pinnacle Investment Management Limited ABN 66 109 659 109 AFSL 322140. Any opinions or forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information at the date of publication and may later change without notice. Any projections contained in this article are estimates only and may not be realised in the future. The information is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. This communication is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice relevant to their particular circumstances, needs and investment objectives. Past performance is not a reliable indicator of future performance. Interests in the Firetrail Absolute Return Fund (ARSN 624 135 879) and Firetrail Australian High Conviction Fund (ARSN 624 136 045) (‘Funds’) are issued by Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371. Pinnacle Fund Services Limited is not licensed to provide financial product advice. A copy of the most recent Product Disclosure Statement (‘PDS’) of the Funds can be located at www.firetrailinvest.com You should consider the current PDS in its entirety and consult your financial adviser before making an investment decision. Pinnacle Fund Services Limited and Firetrail believe the information contained in this communication is reliable, however its accuracy, reliability or completeness is not guaranteed and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Firetrail and Pinnacle Fund Services Limited disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information.

Matthew Fist
Portfolio Manager
Firetrail Investments

Matthew is a Portfolio Manager at Firetrail Investments for the Firetrail Australian Small Companies Fund. Matthew’s primary sector responsibilities are Resources and Industrial Small Companies. Matthew has over 13 years’ relevant industry...

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