The small-cap resurgence: why now is the time to invest

Over the past few years, small cap stocks have faced headwinds beginning with the start of the Russia/Ukraine war in 2022 and exacerbated by the inflationary pressures experienced over the past three years. However, we believe we are now on the cusp of a turnaround, with economic conditions shifting in a way that could breathe new life into small cap stocks. Put simply, we believe the February 25 basis points cut from the Reserve Bank of Australia signals the beginning of small cap outperformance, particularly given that over the past three years, small cap companies have underperformed the broader market by 8.5% p.a.

Since the New Zealand central bank started cutting interest rates back in July 2024, small cap companies have outperformed by 13.2%. We believe this trend will unfold in Australia.

The leverage advantage of small cap stocks

One of the key reasons small cap stocks hold so much potential is their inherent leverage – both operationally and financially. Unlike their larger counterparts, small cap companies typically carry more leverage on their balance sheets and in their business operations to drive faster growth. This means that even the slightest economic tailwind can fall to the bottom line quickly and drive earnings upgrades.

At Wilson Asset Management we have observed these trends across multiple cycles since we began in 1997, and we now believe small caps are well-positioned with a unique opportunity to capture strong gains as the market adjusts to changing monetary policy. We also think a more stable macroeconomic environment should result in increased capital market activity, which has been lacking over the last three years.

Interest rate cuts: a catalyst for small cap resurgence

One of the most significant drivers behind this anticipated rebound is the shift in interest rate policy. As rates begin to decline—or at the very least, stop increasing—the pressure on small cap companies eases.

Approximately 35% of the small cap market comprises stocks exposed to the consumer in sectors such as automotive, retail, travel media, building materials and property developers. Due to the rising interest rate environment and in turn, the tough consumer environment we have seen since 2020, these companies have struggled to generate top-line revenue growth. At the same time rising inflationary pressures have impacted margins. Small cap companies tend to have higher levels of financial leverage than larger companies and as a result, rising interest rates have increased interest expenses, impacting profitability for these companies over the last three years.

We believe that a sustained decline in interest rates can reverse this dynamic and small cap companies are poised to recover and enter an earnings upgrade cycle. The fear of further rate hikes has been a major overhang and with this concern now dissipating, we expect renewed optimism to drive up valuations. We have certainly seen this in the recent reporting season where several previously unloved and heavily shorted companies such as Corporate Travel (ASX: CTD), Dominos (ASX: DMP) and Nick Scali (ASX: NCK) have performed very well despite a tough first half result and a cautious outlook for the remainder of the year.

Sectors poised for growth

While the overall small cap sector looks promising, not all industries will benefit equally from these changes. The WAM Capital (ASX: WAM) investment team has identified several opportunities emerging in the automotive, retail, childcare and property sectors, where structural advantages and consumer sentiment shifts are driving renewed growth potential.

For instance, in the automotive sector, companies such as automotive and consumer products company Amotiv Group (ASX: AOV) and Eagers Automotive (ASX: APE) stand to benefit significantly from easing inflation expectations and improved demand for new and used car sales. In retail, established names like Harvey Norman (ASX: HVN) and Myer (ASX: MYR) are well-positioned to capitalise on improving consumer spending, particularly in housing. Childcare is another sector to watch, with childcare operator G8 Education (ASX: GEM) benefiting from improved occupancy rates and government support. The team is also positive on undervalued building material companies Maas Group (ASX: MGH) and Brickworks (ASX: BKW), believing that the market value of both companies’ assets significantly exceeds their current share prices.

Why now is the time to invest in small caps

Despite the challenges small cap stocks have faced in recent years, we are confident that we are entering a new phase of opportunity. The combination of declining interest rates, a stabilising economy and sector-specific tailwinds creates a compelling case for renewed investment in small caps.

Investors willing to navigate this transition and identify strong companies with sound fundamentals will likely be rewarded. While volatility remains a factor, history has shown that small caps tend to outperform when economic conditions improve. Now is the time to take advantage of what could be the beginning of a powerful small cap resurgence in Australia.