Active Small Caps: Catching up and Standing Out

Volatility reached a 15-year high in August as companies were rewarded or punished almost instantly on earnings revisions. Gone are the days when markets “drifted” for months post-result — stocks now reprice within days.

Figure 1: Multi-year high price variation this reporting season

So where does that leave small caps? While we do not have a crystal ball, we believe that the market outlook is positive. The Small Ords Index is catching up to the ASX100, active small caps continue to outshine and valuations remain attractive. Below we explore the current market outlook, the drivers behind recent performance, and key lessons from reporting season.

The opportunity in Active Small Caps

Active small caps: the long-term outperformer
Over the long run, active small caps have been the highest returning asset class on the ASX. Yet the benchmark Small Ordinaries Index has historically lagged its large-cap peers on a total return basis (Figure 2).

Figure 2: Active Small Caps are not only outperforming the Small Ords Index, but also the ASX200 and active large caps

That gap is starting to close. Since the end of July to the close of market yesterday (22 September), the Small Ords Index is up +10.2% compared to the ASX100 which is down 0.15%. Over this same period the Firetrail Australian Small Companies Fund is up +15.3% (gross).

Figure 3: Small caps are closing the gap on large caps

Attractive entry point

Despite the rebound, valuations remain compelling. On a price-to-earnings-growth basis, the Small Ords is one of the cheapest indices globally (Figure 4). Bottom-up opportunities are elevated, and we are starting to see another wave of ECM activity that has historically contributed ~20% of excess returns for the strategy.

Figure 4: ASX Small Ords is one of the cheapest indexes in the world on a growth-adjusted basis

How Firetrail is positioned

Having looked at the asset class more broadly, it’s worth considering how we are positioned within it. While the Small Ords has only recently begun to close the gap on large caps, we’ve been able to capture a greater share of the opportunity. Over the past year, the Firetrail Australian Small Companies Fund has outperformed the Small Ords Index by 12.5% (after fees), and since inception in February 2020 has delivered 12.3% pa excess returns (after fees).

Key drivers of outperformance
Several themes have powered the recent outperformance in the fund:

• Gold: Now ~16% of the Small Ords Index, gold remains under-researched despite its size. We see bottom-up opportunities in Genesis Minerals (ASX: GMD ), Greatland Gold (ASX: GGP ) and Orezone (ASX: ORE ).
• Defence: Australia has some great export orientated defence companies and many of these exposures are up >100% CYTD. Whilst we continue to stay clear of the overhyped names, key exposures include Duratec (ASX: DUR ), Elsight (ASX: ELS ), and Shape (ASX: SHA ).
• Consumer discretionary: recent rate cuts and consumer confidence have seen a resurgence in many domestic cyclicals. We continue to see great alpha in this part of the market including Baby Bunting (ASX: BBN ), Autosports (ASX: ASG ), and Nick Scali (ASX: NCK ).

Reporting season recap

By contrast, Firetrail’s small cap portfolio delivered +15.8% positive revisions (Figure 6), with 10 out of 12 thematic buckets contributing positively. Importantly, more than 80% of our risk remains stock-specific rather than concentrated in sectors or broad thematics. This discipline ensures performance is driven by company fundamentals, not market swings.

Figure 5 and 6: Broader market disappointed on earnings while our holdings delivered upgrades

Past performance is not a reliable indicator of future performance.

The bottom line