It pays to be small minded

Weak equity markets, falling interest rates, small cap stocks outperforming: these were just a few of the predictions from market watchers which proved wide of the mark in 2024. Add that to geopolitical uncertainty and the ability to reliably predict trends, and it is clear that investing in 2025 is clearly a high-risk game. Against that backdrop, we continue to focus on what we do know. Central to that is continuing to invest for the long term in companies with durable business models, cash flow generation and the ability to withstand uncertain times.

The ingredients for small cap outperformance are in place

While the Australian Small Cap sector (ex-ASX 100) had a year of solid absolute returns in 2024 the asset class recorded its third year in a row of underperforming the Large Cap sector (ASX 100), thanks to share price strength in the banking sector and strong momentum in high growth, high multiple industrials.

Looking forward, the pre-conditions for small cap outperformance are in place: a backdrop of falling interest rates (which tends to be supportive of small cap outperformance), with more compelling earnings growth and better relative valuation support.

Chart 1 – ASX 100 vs. Small Ords Total Return

We are hunting market share winners

Within the small cap sector, we continue to be attracted to market share winners. Growing through product innovation, market and geographic expansion or through acquisition, these companies have the ability to take market share and grow faster than underlying economic growth.

We have found these companies in funds management, platforms, insurance broking, technology, infrastructure and even agricultural products such as olive oil.

Global shifts will be important to watch, even for small caps

In the aftermath of COVID, companies began actively diversifying their supply chains. Post the US election a new trend – “near-shoring” – is emerging. Companies are seeking to get closer to their customer base and shifting supply arrangements to ensure they are not locked (or priced) out of markets.

This trend has far-reaching implications for manufacturing, transport providers and supply chains as trade flows react to this shift. The value of incumbency in the US market is likely to increase with trade barriers, making it more challenging to compete.

We have a number of companies (such as Breville (ASX: BRG)) in our portfolio with strong existing businesses in the US. For those companies who have successfully navigated the supply chain shifts there is a meaningful opportunity to win further market share.

The attraction of long duration assets in a falling interest rate environment

With a strong inverse correlation to interest rate movements, due to the value of long duration cashflows, the appeal of long duration assets is likely to improve as local rates fall in 2025.

Infrastructure companies like airports (such as Auckland Airport (ASX: AIA)) with an ability to deploy capital at high rates of return and property asset owners (in particular, select industrial and retail assets) will see their cashflows revalued. These companies can be highly attractive, able to grow and compound earnings growth over time.

Momentum is important short term; cash flows and valuation should matter long term

Momentum, particularly revenue momentum, has been the key driver of equity performance in 2024. While revenue momentum is important, we also think about the durability of revenues, the ability to scale businesses to deliver attractive margins and free cash flow generation. We continue to invest against long-term timeframes and expect cashflows and valuations to be the key drivers of performance for the period ahead.

Looking for a small fortune?

Our Australian Smaller Companies Strategy invests in companies listed on the ASX that we believe will provide solid and consistent risk-adjusted returns with strong capital growth. Find our more here.