Australian small caps: a coiled spring so far this AGM season

Key takeaways

A rare performance gap, and history suggests it can close sharply

Australian small caps (S&P/ASX Small Ordinaries Index) have underperformed large caps (S&P/ ASX 100 Index) by 19% over the past 12 months. October alone widened the gap by more than 8% as higher-than-expected inflation revived expectations of further interest rate rises, while elevated global bond yields, continued geopolitical tensions, artificial intelligence (AI) funding concerns and subdued AGM commentary weighed on sentiment at the smaller end of the market.

Rising rates hit Australian small caps particularly hard: smaller companies carry more floating rate bank debt, and the small-cap index is more heavily weighted to domestic consumer discretionary stocks, real estate investment trusts (REITs) and AI-related growth stocks. Large caps, by contrast, are cushioned by banks, whose margins tend to benefit from higher rates, and by major miners.

Since 2002, there have been only three comparable periods of Australian small-cap underperformance, each with a different trigger but a similar outcome.

Unlike the GFC, this is not a credit crisis. Funding has become more expensive and selective for capital-intensive businesses, but it has not frozen, and Australian small-cap balance sheets are healthier, reducing the need for the large, dilutive capital raisings of 2008/09. Unlike 2013, this is not a commodity bust. Most commodity prices remain elevated despite the recent pull-back, and small-cap miners are now weighted more towards low-cost producers generating cash than towards exploration companies reliant on capital raisings.

Together, these differences mean a recovery could draw on two sources: a re-rating from below-average valuations and a return to earnings growth. We therefore believe the conditions are in place for a recovery (potentially a sharp one) once inflation and rate pressures ease.

AGM season so far: 10 key investment insights

Positioning for earnings, not interest rates

We assess companies individually rather than building the Maple-Brown Abbott Australian Small Companies Fund (‘the Fund’) around economic or interest rate forecasts. We believe earnings drive share prices, so we invest in undervalued businesses with resilient medium term earnings prospects and company-specific growth drivers, avoiding those facing likely earnings downgrades.

Against the current challenging backdrop, we favour established, profitable businesses with net cash or manageable debt that can fund their own growth and have clear reasons for earnings to improve.

Four investment themes and stock examples

Five catalysts that could release the spring

1. Rates at or near their peak: The RBA lifted the cash rate to 4.85% on 3 November – its fifth rise this year and the highest level since 2008. The decision also carried an encouraging message. Three of the nine Board members voted to keep the cash rate unchanged, and the RBA removed its explicit commitment to raise rates further ‘if needed’. In our view, this sets a much higher bar for any further increase, and markets now expect rates to stay broadly flat over the next 12 months. This matters because the economy is already weak: growth is well below trend, unemployment is rising and house prices are falling. Australian small caps may need only an end to rate rises, not rate cuts, to recover.
2. Compressed valuations: Australian small caps’ forward price-to-earnings ratio is now well below its long-term average, both in absolute terms and relative to large caps.
3. Higher yields than large caps: For the first time since 2002, Australian small caps offer a higher dividend yield than large caps, paying investors to wait.
4. Takeover interest: Takeover activity is concentrated at the smaller end of the market across a range of sectors and has increased since the start of the 2027 financial year, as offshore and private equity buyers see value emerging.
5. Stronger expected earnings growth: Australian small-cap earnings are forecast to grow faster than large-cap earnings in FY27 and FY28.

What could change our view

On the upside, faster-rising unemployment or cooling inflation could prompt the RBA to shift from holding to easing earlier than markets anticipate, although a turn driven by rising unemployment would also mean weaker demand and further earnings pressure before rate relief feeds through. Australian small caps have historically rallied hard on an early turn in the rate cycle, which could leave underweight investors behind. We believe the Fund’s self help holdings, which stand to benefit from both company-led improvements and a domestic recovery, provide exposure to that upside.

The bottom line: tough conditions, but a tightly coiled spring

For investors, now may be an opportune time to review allocations to Australian small caps against their long-term targets.