Why invest in small caps now

You won’t find too many cheerful small cap fund managers around the world. The past three years have seen severe small cap underperformance. Larger stocks offshore have been driven by the NVIDIA (NASDAQ: NVDA) juggernaut and the rest of the Magnificent Seven tech favourites. In Australia, the Commonwealth Bank (ASX: CBA) made historical highs last quarter with the other big banks in tow. 

Over the last three years, an investor in the Australian small cap index has underperformed large caps by 25%. In the US small caps have also underperformed by 25%. Globally that number is 17%.

So why bother investing in small-caps? And why now?

Valuations are More Attractive

‍Australian small companies have historically traded at a 10% price to earnings premium to the larger stocks. After a torrid three years (from elevated levels), they are now trading in-line. 

Why should they trade at a premium? 

The driver is mostly the faster earnings growth found amongst Australia’s small caps. In normal years earnings growth expectations hover at or below 5% for large caps. For small caps, earnings growth expectations are more variable but regularly clock speedy growth north of 10%. While not all of this will be realised, the space to look for quickly growing businesses at attractive valuations is in small caps.

Sensitive small stocks

Smaller stocks are often more susceptible to tougher economic conditions. Smaller companies are less diversified by geography and end market. They also have higher levels of floating rate debt. A larger portion of smaller companies are loss-making. 

And whether in Australia or overseas, higher interest rates have tightened economic conditions. 

Global central banks are now riding to the rescue of these difficult conditions. With inflation now more controlled, expectations are for rate reductions across the world. 

In late September we got the first US rate cut of 0.5% to a range of 4.75% to 5%. By mid-2025, bond investors are predicting six rate cuts in both the US and the Eurozone. Australia is expected to see three rate cuts with the cash rate hitting 3.6%. 

For the past 30 years the first US interest rate cut has ushered in a period of small cap outperformance of large caps. In Australia, the year after the first US cut saw small caps outperform large caps by 8%. In the US and globally the figure is 6%.

We continue to focus on small caps, with 80% of the Forager Australian Shares Fund invested in stocks below $1 billion of market capitalisation. The key to investing in small caps is careful stock selection - and that should help position portfolios for any recovery.

This is an excerpt from the September 2024 quarterly report