Large caps look expensive. The small caps opportunity and five to watch

It’s easy to point to market performance in the last few years. Large caps have absolutely dominated markets and the AI push has seen the Magnificent Seven rise to extraordinary valuations.

It’s been a tougher environment for small caps, despite low interest rates. Initial cuts in late 2025 suggested a rally might be coming and then 2026 hit. We all know that story.

Inflation and rising rates have traditionally been hard environments for small caps to perform in – the rates make it harder for small caps to borrow and grow and inflation hits earnings. It’s not the end of the small cap story though and there’s still much to like about the space.

Steve Johnson, Founder and Chief Investment Officer for Forager Funds Management reminds investors that the inflation and rates cycle will eventually shift.

“I do think from today’s valuations though, small caps can play a great role in your portfolio,” he says, pointing to the high valuations in large caps and noting that equities broadly have returned 7-8% over the long-term

“It won’t be a smooth ride, but I think small caps can do better than this over the long-term and that, if it’s a decade of lower returns elsewhere, can be a very valuable thing.”

In this article, he shares his views on the market and outlook for small caps along with 5 opportunities he likes for the next five years.

Watching the market

US small caps v large caps

The story of large cap outperformance compared to small caps is not as simple as index performance suggests.

Johnson explains there are two factors driving outperformance.

“One is the strong and persistent growth in passive index funds and Australia’s superannuation giants. Both skew towards larger companies and it’s a multi-decade trend that looks unlikely to end,” he says.

“The second reason is that large companies have been some of the biggest beneficiaries of the themes that investors are most excited about – namely the AI boom and commodities,” he adds, pointing to Nvidia, Alphabet and Amazon in the US and the big miners in Australia benefiting from a boom for copper and gold.

Both of these factors can benefit small caps though.

Johnson notes that when small caps become large enough to enter indices and attract passive flows, they can see huge upside. He cites the examples of Cuscal (ASX:CCL), Catapult (ASX:CAT), Bravura (ASX:BVS) and Navigator (ASX:NGI).

Factoring the AI trend too, some small caps have benefited even more than large caps in Australia.

“SKS Technologies is a good example here in Australia and Comfort Systems in the US. Comfort Systems was a boring HVAC company that became an AI winner and its share price appreciated more than four times,” Johnson says.

Following the opportunities

There have been growing market concerns over stretched valuations in the large-cap space and this poses some risk to future returns.

“Long-term returns from equities have been 7-8%. Given the overvaluation of large caps, you should be happy if you get that over the next decade,” he says, viewing small caps as offering more potential over the long-term.

Johnson believes that some of the structural drivers for outperformance in the large-cap space aren’t going anywhere, such as passive flows, so it’s not a case of ‘piling into small caps’, but rather selective inclusion.

He sees three key sources of returns over the coming year.

1. Self help

Despite the macro environment, Johnson says some of the problems in his portfolio have related to management execution instead.

“At companies like ASX-listed EML (ASX: EML) and Praemium (ASX: PPS), better execution will deliver better share price returns given the currently-low expectations.”

2. Takeovers

Johnson has seen a number of smaller companies be taken over on the ASX and expects this trend to continue.

“I’m expecting a lot of return realisation to come via takeover.”

3. Capitalising on structural drivers

“Finally, finding those stocks that can capitalise on the passive flows by growing enough to get included in the main indices.”

Five stocks for the next five years

“Despite a recent bounce, I still think software is a great opportunity. Share prices are cheap, the recurring-revenue business models are some of the best we have ever seen and I think the ones we own can adapt to an AI-first world,” says Johnson.

Two stocks to watch in the software space?

1. Catapult (ASX: CAT)

 

Catapult is engaged in the development and supply of technologies that improve the performance of athletes and sports teams. Forager had sold positions in Catapult in 2025 off the back of stretched valuations and repurchased it early in 2026 for the Forager Australian Shares Fund as prices fell in the SaaSpocalyse.

“Its systems contain years of athlete data and sit at the centre of how coaches make decisions. The cost to elite sporting organisations is relatively low, yet the potential value of improving performance can be enormous. That combination of low cost, valuable data and integration into daily workflows makes the product difficult to replicate,” Johnson says.

2. Sage (LSE: SGE)

Sage is an enterprise software company that provides accounting, financial management, payroll and human-resources software for small and mid-sized businesses. It was one of the largest positions in the Forager International Shares Fund at the end of July and had five consecutive quarters of organic revenue growth by the end of July 2026.

Focusing in on the self-help and takeover front, Johnson nominates three stocks:

1. Tyro Payments (ASX: TYR) 

Tyro is an Australian finance business with a one-platform system to manage payments, money and scale from in-person to online payments and banking. The business has been a takeover target for a few years now, with a failed bid from Potentia Capital in 2023 and reported interest from Stripe in 2025.

2. Praemium (ASX: PPS) 

Praemium is an investment platform provider for financial advisers, stockbrokers and high-net worth investors. It automated a significant amount of its IT workforce when it acquired Technotia Laboratories, reducing its annual salary costs early this year. It also continues to be a takeover target, for example Netwealth attempted to takeover in 2021, while Viburum announced a 5% stake in March 2026, becoming the largest shareholder.

3. Motorpoint (LSE: MOTR)

Motorpoint is an automotive retailer specialising in nearly new and used cars in the UK.

“We are spending a lot of time on the auto-sector globally and own stocks from manufacturing and distribution through to retailers in China and Australia. It is going through a lot of change, and change usually brings opportunity,” Johnson says.

The small cap opportunity

While the environment remains challenging for small caps, valuations are positive compared to larger caps and investing is for the longer term. Taking a selective approach can uncover opportunities that can compound over time in a portfolio – just watch the fundamentals and the industry the business operates in.

Are you investing in software or small caps generally? Let us know your picks in the comments.