6 reasons why small caps will deliver in 2024 (and 13 stock ideas)

We believe the Australian small cap index has hit bottom and will not re-test the lows it established in October 2023. We believe several good signs for the sector support our bullish expectations for the next year.

We expect small caps to deliver a strong performance in 2024:

Share price action is positive - In late October 2023, markets hit bottom, US bond yields declined, and share prices rallied. The link between US 10-year bond yields and equity markets is well established. In November 2023,  US 10-year bond yields decreased from a peak of 5.0 per cent. The move in rates delivered a strong rally in global equities as markets re-priced risk. 

We believe rates have peaked and for the the first time in the current rate cycle, leading commentators are now suggesting US interest rate cuts are possible in mid-2024.

Post-Covid 'bull' market to resume - In early January 2024, the S&P/ASX200 index traded to a high of 7,632.7 versus an all-time high of 7,632.8 in August 2021. A key question remains - can the market trade through all-time highs and move to a new record high in 2024? We think it can. Provided inflation continues to moderate, interest rates stabilise, and GDP growth doesn’t stall, the Australian equity market looks likely to extend the post-Covid ‘bull’ market that commenced in 2020. We expect increased exposure to higher-risk small-cap investments to enhance performance next year.    

Two positive US quarters normally signal a bull market -  Post a bear market, two positive quarters signal the start of a bull market. In the US, the end of the last three major bear markets has been followed by two consecutive S&P 500 index quarterly gains. The S&P 500 has delivered exactly that result, with the December quarter of 2022 up +7.1 per cent and the March quarter of 2023 up +7.5 per cent following its bear market correction over the first nine months of calendar year 2022 - when the index fell -25 per cent. In CY23, the S&P 500 index returned +24.2 per cent.  

The US equity market historically leads the Australian market and we see the performance of the S&P 500 as being a positive lead indicator for the Australian equity market.   

Rally delivering better market breadth - In Australia, one recent positive has been the strong rebound in small caps compared to large and mid-caps. For most of the last two years, the reverse has been the case, with large caps outperforming small caps in the risk-off environment. In the US, the small-cap trend has been the same. The Russell 2000 has outperformed the S&P 500 as the breadth of the recent rally has broadened.  

Investor sentiment has started to improve - It is early days, but there are signs that small-cap investor sentiment is improving. Specifically, M&A activity has increased, shareholder equity sell-downs have become more frequent and corporate capital raisings are being successfully undertaken. Both the frequency and size of capital market activity have increased post-October 2023. The next test will be the initial public offerings market. At this stage, the IPO market is closed but we suspect it opens in March quarter 2024.  

Small caps have underperformed - The chart below demonstrates the significant underperformance of small caps vs large caps in the recent cycle. We are confident the trend is set to reverse.

Source - E&P Financial Group

Investment themes for 2024:

Cyclical upturn - Potential rate cuts in the US in mid-2024 will help the cyclical upturn in company valuations that began in late 2023. We regard the US rate cycle as the most important lead indicator for global equity markets. While the economic cycle in Australia is 9 to 12 months behind the US, and rate cuts in Australia are expected to lag the US, we expect the equity markets to rally through 2024/25 as investors begin to price anticipated rate cuts and an improved outlook for company earnings.     

Cyclical stocks (housing, building materials, property developers and housing exposed retailers) normally perform well in the first phase of a rate cutting cycle.  

Balance sheet strength and margin leverage - Balance sheets in corporate Australia are well capitalised, and most businesses have focused on lowering costs in the last 18 to 24 months. We believe wage increases peaked in 2024, which will improve company operating margins and profitability in 2024/2025. As a result, as the economic environment improves, we expect 'cyclicals' to deliver margin leverage and increase profitability over the next 12 to 18 months.

Importantly, small cap tech valuations have lowered materially and many companies have rapidly moved from a loss making/cash burning position to a breakeven or positive EBITDA footing. Within the sector, revised valuations and lower cost bases present selective investment opportunities. 

Stock ideas for the small-cap recovery

Housing-related exposures:

• Beacon Lighting (ASX: BLX)
• Nick Scali (ASX: NCK)
• Adairs (ASX: ADH)

Non-bank lenders

• Resimac (ASX: RMC)
• Australian Financial Group (ASX: AFG)

Building Materials

• James Hardie (ASX: JHX)
• Boral (ASX: BLD)
• CSR Limited (ASX: CSR)
• Reliance Worldwide (ASX: RWC)
• Reece (ASX: REH)

Technology

• RPM Global (ASX: RUL)
• Ansarada (ASX: AND)

Financials

• Bell Financial Group (ASX: BFG)