4 compelling reasons to add small companies in 2025

Australian small and micro-cap equities have been promising a resurgence in returns. We think there are four compelling reasons small and micro-cap equities are set to benefit in 2025.

1: A positive macro-economic environment for equities in 2025, particularly small caps

Emerging markets equities have derated for more than a decade. Despite very attractive valuation, the majority of investors are only “lightly” positioned in the asset class. Investor sentiment remains lukewarm.

The reality is rather more exciting because the fundamentals of these economies are robust, and they offer sustainable economic growth in a slow global environment. Many of these EM economies are in better fiscal and financial health in comparison with the developed world. These economies stand to deliver healthy and consistent economic growth in the coming years.

2: In the positive economic environment, we are expecting a resurgence in relative performance

2024 was a good year for equities. Since the date of the last rate hike, small and micro-cap equities have generated a significant return alongside the broad market S&P/ASX 300. For the year to 31 October, the S&P/ASX Small Ordinaries Accumulation Index delivered a return of +27% while the S&P/ASX Emerging Companies Accumulation Index achieved a return of +28%. 

Not only has the market rallied, we are also seeing a broadening across sectors and key return drivers, including cyclical and structural growth.

We believe this return partly represents the positive impact that interest rate normalisation has had on equity markets. However, we believe that with interest rates stabilised, and inflation adjusting downwards, that companies are now in an equity-positive environment backed by an improving economic growth outlook. 

For some context, despite a strong year of returns for equities in 2024, there remains a significant performance disparity between small and large-cap equities (Figure 1). 

Figure 1: On relative performance, small caps are due a positive reversion

With relatively low liquidity (Figure 2) compared to the past, we believe the small cap market is not overcrowded, meaning that more opportunity currently exists for astute active small and micro-cap investors.

Figure 2: Small-cap liquidity is on the rise (rolling three-month average)

However, more recently, market liquidity has improved as cash moves into equities, particularly from passive investors and larger equity managers, to chase better returns in small caps, which should assist with a broader small-cap market re-rate.

3: Small companies tend to be more rewarding for active strategies

The rich environment for generating outperformance in small caps is demonstrated in Figure 3, which looks at small-cap manager returns over the last 20 years compared to the benchmark. 

From the chart, even small cap managers that had generated 20 years of returns that put them into the lower quartile of managers were able to beat the index over the long-term. This is because active investors can seek edges that have shown to deliver better results than the overall market, for example companies that are founder-led, have globally addressable markets and observable barriers to entry for their businesses. 

Active investors can also engage the leadership of companies and assess the quality and vision of the teams involved, often yielding a clear picture of whether a company is setting itself up for the future or is doomed to underperform.

Figure 3: Small caps tend to reward active management

4: Some small caps stocks are offering compelling earnings growth potential in 2025, but some sectors are not

A number of structural growth companies are offering considerable future potential, especially in the financial sector, like Generation Development Group (ASX: GDG), HUB24 (ASX: HUB) and Netwealth (ASX: NWL). We believe these companies have been able to leverage leading technology platforms to offer greater choice and a superior customer service experience at a comparable or lower cost in the forever compounding wealth and superannuation sector.

Focusing on GDG, the company is a specialist provider of financial solutions such as investment bonds, market-linked annuities and managed accounts. We like GDG’s recurring and predictable revenue stream, underpinned by structural tailwinds in their investment bond business and the Lonsec business. Funds under management for the Investment Bond business are up 30% YoY, with the potential for flows to accelerate.

The Lonsec Managed Accounts business is forecast to grow at around 17% per annum for the next five years. Both these businesses are driving what we think is a double-digit earnings growth outlook in the coming years, making GDG a compelling structural growth opportunity.

Communications companies are benefitting as the enablers and distributors of new technology, applications, increasing digitisation and exponential data demand with AI. This includes NBN challengers in Aussie Broadband (ASX: ABB) and Superloop (ASX: SLC), the David Teoh-backed Southeast Asian telco disrupter Tuas Ltd (ASX: TUA), and global communications company, Codan (ASX: CDA). NBN challengers like ABB and SLC are taking NBN market share from incumbent players like Telstra, Optus and TPG. 

Challengers were at only around 10% market share in 2022 but have since grown to approximately 20% of the market in 2024 by providing superior customer service at a comparable or lower price for the same speed tier. SLC has around 6% of the market with ABB at 8%, and we believe this challenger segment of the market can reach over 30% in market share, representing a 50%+ revenue growth opportunity for these businesses.

SLC’s planned build-out of its infrastructure-like assets and its recurring revenue streams is something for which we think the market will pay a higher multiple than other peers in the sector. ABB is a founder-led business with strong industry dynamics that are providing telco challengers with a clear growth trajectory over the coming years. ABB has just reiterated guidance with a number of Enterprise customers signed, and a significant energy customer win in Red Energy.

Another opportunity that has caught our interest is Zip Co (ASX: ZIP). Zip offers US Dollar exposure in a huge addressable market and with the benefit of a strong US Dollar tailwind for earnings. The beginning of a rate easing cycle in the US has seemingly been the catalyst for a rerating of ZIP, and the business has scope to further build out the merchant and payment ecosystem in the US (in addition to Stripe).

Areas to avoid given prevailing conditions include capital intensive, low growth and indebted real estate investment trusts, small resources with poor cashflow and low-quality assets, speculative retail dominated meme stocks, and overpriced tech names that are not benefitting from fundamental structural demand drivers.