Small Caps surge ahead: Why 2026 could be a breakout year

At the time of writing, the ASX Small Ords has rallied +21% for CY25, far outstripping the ASX100’s +8% return. This stunning performance reflects the earnings momentum of Australia’s small companies cohort, which is hitting an inflection point, with earnings growth up 7% after two consecutive years of decline. This positive momentum is expected to continue through FY26, with earnings growth of 10-15% likely to be delivered.

It is noteworthy that small company earnings growth rates are expected to be materially higher than for larger companies in FY26, continuing the trend from FY25 (refer to Chart 1).

The improving earnings growth outlook is being supported by economic growth accelerating in Australia from a cyclical low point, market share gains, margin expansion from depressed levels as cost inflation moderates, interest cost reductions and capital deployment supporting earnings growth through higher capital expenditure and M&A.

The small companies market has a large number of companies earlier in their business cycle, with greater potential to grow independent of economic cycles. The portfolio owns a large number of companies with significant market share upside in their respective markets, including on a global basis.

We expect interest rates to fall further during 2026, contrary to consensus expectations. Historically, both in Australia and globally, small companies have outperformed during periods of declining interest rates. Lower rates stimulate the more cyclical parts of the economy, which small companies are more exposed to, and with lower debt financing costs further supporting earnings growth.

In addition to the more attractive earnings growth outlook, small companies also have more attractive valuations relative to their large company peers, with small company P/E multiples trading at a material 10% discount to large companies and at a discount to historical average levels at 16x forward P/E (refer to Chart 2).

The small companies market also has the advantage of being a more diverse investment universe compared to larger-cap equities, both in Australia, where the concentration of major banks stifles diversification and globally, where the technology sector dominates.

Australian cyclicals stand out as a portion of the market with many compelling investment opportunities. Domestic cyclicals benefit from a depressed starting point for earnings, offering cyclical demand upside and a greater benefit from falling interest costs. They also have materially lower earnings risk from US tariffs. In addition to cyclical upside to earnings, these companies have a market share opportunity, a stronger ability to expand margins and the ability to deploy capital to further grow earnings, supporting a strong multi-year opportunity.

Two companies with these characteristics are Centuria Capital (ASX: CNI) and Baby Bunting (ASX: BBN). CNI is benefiting from improving property sector valuations and asset class inflows, while BBN remains a category killer that is well placed for continued market share growth from its core product set and upside through further adjacencies.

The Resources sector also presents multiple opportunities in the year ahead, particularly across copper and rising exploration activity.

Our positive view of copper reflects the increasing demand for the commodity from both structural demand growth for electric vehicles, renewables, transmission and data centres, and economic activity more generally. Furthermore, the copper supply side is highly constrained, with long lead times for new mines and grades declining for existing mines. Capstone Copper (ASX: CSC) will benefit from increasing copper prices and offers additional upside from significant organic volume growth and an improving position on the cost curve.

Exploration markets are expected to recover from cyclically depressed levels with structural growth from increasing resources demand and new mines being deeper and lower grade. We expect Imdex (ASX: IMD) to benefit from market growth in addition to having a global market share opportunity via a compelling product set, including across its various technology solutions.

High-quality Infrastructure opportunities are also prevalent, with our preferred exposures Auckland Airport (ASX: AIA) and Chorus (ASX: CNU). We believe the strategic value of these assets is being undervalued, given short-term headwinds from the New Zealand economy, cyclical weakness in airline volumes and legacy copper headwinds. Taking a longer-term view, both companies have strategic assets which will benefit from an accelerating earnings growth outlook with strong balance sheets to fund growth capital expenditure or higher distributions.

An ever-present risk to avoid in the small companies market is the rise and fall of concept stocks. While the performance of these stocks can be extremely positive over short periods of time (aided by passive investing), these businesses prove to not be durable over the longer term, failing to generate sustainable free cash flow, with share prices collapsing back to reality. The rise and fall of a number of defence and pre-production commodities companies during 2025 were examples of the risks associated with concept stocks.

Investors should be excited at the potential returns from the Australian small caps in 2026. They enter the year with strong tailwinds, underpinned by accelerating earnings growth, attractive valuations, and supportive macro conditions. With expected earnings growth of 10–15%, a material valuation discount to large caps, and greater exposure to cyclical recovery and falling interest rates, the sector offers a range of compelling alpha-generation opportunities for bottom-up, active investors.

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Yarra Capital Management is powered by a large team of senior professionals who are part-owners of the business. With a home-team of more than 80, including 30 investment professionals, we are committed to chasing down superior returns for every investor. We value research, insight and analysis that helps us identify the best opportunities for superior and sustainable returns over the longer term. Our distinctive investment approach capitalises on viewpoints from both our Australian equity and fixed income teams. 

Please note, this wire is part of Livewire's Ultimate Investing Guide for 2026. The full guide is available for download here.