Why small-caps look very attractive (and 2 ASX stocks for 2024)

Many fund managers, investors and market enthusiasts keep talking about Small Caps being a great place the invest in 2024 and after two very challenging years, we concur, think the evidence is compelling and remain optimistic that the recent recovery has a long way run.

Small caps generally underperform large caps in the lead-up to an economic slowdown and this cycle has been no exception. As a reminder, the ASX Small Ords was down over 23% at its most recent low in October 2023, and in 2022 delivered 4 of the worst 25 months recorded since Index inception in 1990 (January 2022 -9.0%; May 2022 -7.0%; June 2022 -13.1%; and Sept 2022 -11.2%).

Earnings Per Share (EPS) estimates have been cut by over 30% over the same time period, whilst Price to Earnings (PE) valuation multiples have retreated to attractive levels of ~15.5x. In Small Caps liquidity can be your foe, like the last 2 years has illustrated, but also your friend once money starts to cycle back in which is our expectation for 2024. 

In an investment environment where growth will be more difficult to find in the next few years, Small Cap investing offers excellent earnings growth at attractive valuation levels. 

So where are we today? Consensus forecasts have 9% EPS for the Small Ords over the next 12 months, whilst the LSN Emerging Companies Fund is forecast to generate EPS growth of over 20%, as many of the portfolio holdings continue to grow revenue and expand operating margins. This EPS growth profile is far more attractive than consensus forecasts for the ASX Top 100, where EPS is expected to decline -6% in FY24.

In recent months the LSN Emerging Companies Fund has been increasing exposure to smaller market cap companies as this is where our research is directing us to allocate capital and where we see the most valuation upside. 

Since 2021, ASX Small Industrials Index relative to the ASX Top 20 experienced underperformance of >30% at its lows (see chart below), the worst in >15 years with November/December showing early signs of a recovery. In November/December, ASX Small Industrials (+17.1%) started to outperform the ASX Top 20 (+12.4%), as the underlying investment fundamentals on offer start to become too hard to ignore. 

Specifically, cheaper valuations, superior growth, and a broader sector universe of investable companies. With the recent downside surprise in both US and domestic inflation, markets are now expecting interest rate cuts in 2024, which is a far more attractive backdrop, specifically for investing in small caps and makes us excited about return prospects in 2024.

ASX Small Industrials relative to ASX Top 20

In December, we saw M&A activity in ASX Small Caps start to heat up as potential buyers pounced on mispriced companies, with takeovers across a range of sectors. Dental services business Pacific Smiles Group (ASX: PSQ), building materials business Adbri Limited (ASX: ABC) and administration service business Link Group (ASX: LNK) all received takeover bids in mid-December. Each of these companies has strong market positions in their respective industries and has been trading towards multi-year lows despite improving operating backdrops. This resulted in M&A activity, a theme we expect to continue in 2024.

Two stocks that are very well-placed heading into 2024 in our eyes are Close the Loop (ASX: CLG) and Ooh!Media (ASX: OML).

Close the Loop (ASX: CLG)

Regulation and strong public interest are driving developed economies to a more circular economy, in which printer recycling and product refurbishment play a considerable role. Close the Loop (ASX: CLG) is uniquely positioned as a leader in printer cartridge recycling and electronic device refurbishment to help accelerate this transition. CLG operates significant global infrastructure around waste collection with over 260,000 collection points worldwide providing a strong moat and ability to create and deliver new generational value-add products.

CLG acquired ISP Tek in 2023 and is Hewlett Packard’s authorised refurbisher in North America that interacts with almost two million electronic devices that have been returned to the store, including PCs, laptops, monitors, and printers. This business is delivering strong organic growth from helping its customers achieve their sustainability goals, but the opportunity to leverage its skillset and expand the relationship across both geography and product would deliver a step change in CLG’s growth profile. In addition, CLG’s global printer cartridge recycling platform, with partnerships across sixteen of the world’s largest printer manufacturers, is perfectly placed to benefit from the push for increased volumes of recycled cartridges.

With supportive industry tailwinds, leading market positions and multiple avenues for growth, the company is poised to compound earnings in excess of 10% pa over the medium term, deliver EBITDA margins at >20% and generate over 10% of their market cap in cashflow each year. Given this outlook we see CLG undervalued, trading on 5x EV/EBITDA, and the recent purchase of almost $2m worth of stock by their Board of Directors is further evidence of the internal confidence in their outlook. 

Ooh!Media (ASX: OML)

The out-of-home (OOH) advertising sector is the fastest-growing media segment that continues to take market share from other categories, such as free-to-air (FTA), as well as benefiting from increased digitisation of the OOH category. Ooh!Media is a market leader in OOH in Australia and NZ with diversified operations across road, street & rail, retail, fly (airport) and locate (office), with each category recovering strongly post COVID-19 and OOH share of total media advertising now over 14%, up 50% in less than a decade and still rising. As the digitisation of the OOH advertising sector continues to accelerate, OML has developed a new business that provides a turnkey solution for retailers, known as Reooh, to derive revenue from their digital screens in-store with OML having signed their first major retailer with future new partnerships expected in the months ahead.

OML has very attractive financial metrics trading on a PE of ~15.5x, a yield of ~4% and forecast to deliver in excess of 10% EPS growth in each of the next two years. As we move from 2023 into 2024, we forecast revenue growth to continue as OOH media spend continues to accelerate, whilst disciplined cost control will show attractive operating leverage and improved profitability. OML’s balance sheet is conservatively geared at sub 1x net debt / EBITDA which positions them well for further contract wins. 

OOH share of total media spend

Gross media spend – by category