Active management thrives in small caps

Navigating the Australian small cap market has always required a balance of conviction and flexibility. As geopolitical tensions, volatility in global trade and the drivers of major market fluctuations shape the 2026 calendar year, that balance feels even more important. January is typically a time to revisit portfolio positioning, assess risks and opportunities with one eye on the upcoming February reporting season which serves as a key near-term catalyst for share prices.

Risks and opportunities

As we reach the end of January, the environment has felt similar to the post-COVID recovery period we saw in 2021. Pockets of optimism are returning to the smaller end of town, but expectations around domestic interest rates have shifted notably over the few months. Futures are now pricing in 50bps of interest rate hikes in 2026 compared to approximately35bps of cuts at the beginning of October, dampening an upbeat tone in the industrials sector.

Our view is this: these sorts of inflection points can be uncomfortable and a reminder to remain as nimble and open-minded as possible. They can also be highly rewarding for active investors as markets reprice risk quickly and quality businesses can get sold down indiscriminately alongside everything else. That’s often when we can lean into our investment process and look for undervalued growth companies where the market is discounting the outlook too harshly and earnings upgrades can drive share price re-ratings – recent examples include Codan (ASX: CDA) and Life360 (ASX: 360) which have seen very strong share price reactions to updates that were ahead of consensus expectations.

The impact of divergent interest rate policies

One of the more prominent macro themes we are watching closely is the divergence between the policy settings in Australia and the United States. If what we are expecting plays out through 2026, it’s likely to contribute to US dollar weakness. Historically, that sort of backdrop can be supportive for commodities, and it’s a key reason we’ve been actively increasing exposure across parts of the metals, mining and natural resources sectors.

We’re also seeing more investors reassess resources allocations as momentum returns to the sector. That creates both opportunity and risk for small cap managers, because while the upside can be meaningful, volatility can cut both ways. Position sizing, valuation discipline and catalyst identification matter significantly in this environment.

One of the major calls of 2026 will be in relation to domestic interest rates and whether the two rate cuts currently priced in are the right number; if this proves to be incorrect then it will drive further shifts in positioning between industrials and resources either way.

Leveraging corporate transactions and strategic growth

Another clear feature of the current market is the rise in corporate activity. We’re seeing more companies explore equity raising to advance development in the resources sector. There is still good appetite from the market for Industrial companies to under earnings-accretive acquisitions, particularly where a stronger share price can be used strategically.

At the same time, capital markets remain uneven. In our view, secondary issuances remain active, but initial public offering (IPO) conditions, particularly for industrials, are likely to continue as subdued in the near term. That puts more emphasis on strong balance sheets, disciplined capital allocation and management teams that can move proactively rather than reactively.

Embrace the volatility

Looking ahead, the rest of the 2026 financial year feels set to test investors’ patience. If rates remain higher for longer, we could see conditions that are reminiscent of 2022. That said, markets like this can also be where longer-term opportunities are created, especially when price dislocations become detached from underlying business quality.

For us, the key to succeeding is staying agile. The opportunity set shifts, sometimes quickly, and portfolio management needs to reflect the landscape in front of us. Right now, that means being open to the evolving commodity and resources rally, while still hunting for mispriced industrial opportunities where catalysts are starting to emerge. Policy settings emanating out of the United States and Trump’s “America First” agenda are likely to remain key themes, that encompass critical minerals, onshoring, defence and electrification.

What we take from the current environment is that small cap investing in 2026 will reward discipline and adaptability. Volatility doesn’t have to be something market participants simply suffer through, but in fact can be a source of opportunity for those that can remain selective, focused on fundamentals and can act when the market offers value.

As conditions continue to evolve, we are focused on identifying companies with resilient balance sheets, clear strategic pathways and the ability to create value through smart corporate actions, while ensuring our portfolios remain positioned to capture opportunities across both industrials and resources as the cycle develops.

Key takeaways

• In 2026, economic pressures and the growing chorus of economists forecasting a higher interest rate environment, are creating headwinds for Australian small cap companies. However, opportunities are emerging, particularly across parts of the industrials universe where valuations have been compressed. 
• The divergence between Australian and US interest rate settings is influencing capital flows and currency dynamics, contributing to momentum in the resources and commodities sectors.
• Corporate activity remains important: M&A, balance sheet strength and sensible capital management are becoming key differentiators for small cap companies looking to take advantage of undervalued opportunities.