Small caps trade three P/E points below large caps. The index won’t capture the gap

Australian small caps are trading about three P/E points below large caps on 12-month forward earnings. Since 1996, the gap has reached this depth only a handful of times, in 2000, 2009 and 2013. What sets this episode apart is how long it has lasted. The spread has held near those troughs for two years.

The obvious conclusion is that small caps are cheap and the gap will close. I agree with the first half of that. The second half matters less than most investors assume.

A narrow market has left smaller companies behind

Much of the gap comes from how concentrated returns have been. A small group of large caps and AI exposures has carried the index, while smaller companies have fallen out of favour.

Passive flows reinforce the pattern. Index funds allocate by market capitalisation, so each new dollar goes mostly to companies that have already risen. Smaller companies receive a small share of that buying, whatever their earnings are doing. Higher rates have added pressure. Many smaller companies carry more floating-rate debt and have less pricing power, which leaves their earnings more exposed when financial conditions tighten.

Part of the discount is deserved

A cheap index and a cheap company are different things. The Small Ordinaries includes businesses with stretched balance sheets, falling earnings and forecasts that have yet to be cut. Fewer analysts cover each small company, so estimates can lag what is happening inside the business. That means the headline multiple can flatter the segment. Buying the whole index means owning the companies that are cheap for good reason alongside those that are mispriced.

“We are observing extreme market dispersion between large and small cap companies, which is providing opportunity for skilled small cap investors.”

The gap does not need to close for investors to be paid

The chart shows the spread narrowed after each previous trough. Waiting for the whole segment to rerate is one route to a return. The more direct route is company-specific: an earnings upgrade, a balance sheet repair, or a takeover.

Takeovers are the mechanism I am watching most closely. Private equity holds a large pool of capital waiting to be invested, and listed small caps at discounted valuations offer a cheaper entry point than private markets. When a bidder pays a control premium, the discount closes for that company on the day the bid is announced, whatever the index does.

“Public market valuations for small caps are depressed due to the closure of numerous active management firms and the weight of capital being allocated towards passive strategies that favour large caps. Private capital is preying on the plethora of opportunities available in listed markets.”

Where the opportunity sits

A discount this wide tells you the segment is cheap. Deciding which companies within it deserve capital takes research. The businesses I want to own share three traits: net cash or manageable debt, earnings that are visible one to two years out, and a valuation that already assumes little growth. These are the companies most likely to be repriced, whether by the market, by improving results or by a bidder.

Portfolios built around large-cap benchmarks hold little of this end of the market. Two years at a discount this deep is unusual, and history suggests it does not stay open indefinitely. The return will go to investors who have done the work on individual companies.

I will be discussing how we assess companies within the segment in the webinar “The ASX’s Widest Small-Cap Discount in Years: Which Names Deserve Your Capital?” on Wednesday 18 November at 11 am AEDT.