Small caps vs large caps, the battle shaping the ASX rally

Markets love a comeback story, and small caps are finally getting their turn in the spotlight. After years of underperformance and investor apathy, the past few months have seen the ASX Small Ordinaries surge, outpacing its larger sibling, the ASX200. 

Small-caps, long labelled as volatile high-growth bets, are suddenly back in favour. But are they regaining the mantle for good, or is this just another fleeting rally?

And are large caps, crowded with defensive money, offering value or expensive safety?

To unpack these questions, I turned to Liam Donohue, founding Principal of Lennox Capital Partners, and Joe McCarthy, Investment Analyst at Elston Asset Management. 

What's driving performance - a tale of two segments

After years of being overlooked, small caps are taking centre stage. Donohue believes the conditions are tailor-made for their comeback, pointing out their inherent growth advantage:

"Small companies should offer higher growth than their bigger, more sluggish peers and a lower-interest-rate environment turbocharges that.”

Lower rates have lit a fire under smaller names, while valuations remain compelling. As Donohue puts it, "Small cap valuations are not stretched – if anything, they look like bargains versus many large caps (big banks with earnings going backwards on sale at 30x PE anyone???)"

After years of neglect, he says investor attention is finally shifting back, "Investors have ignored small caps for a few years now and it really is starting to feel like there’s genuine interest in the space.”

On the other side of the market, McCarthy sees large caps caught in a different dynamic. He notes that heightened global uncertainty has triggered a rush to perceived safety:

"Year-to-date, we have seen a flight to safety following the increased economic uncertainty from disruptions such as the tariffs. The large end of the ASX appears largely priced to perfection and growth prospects are limited."

Investors have crowded into the familiar comfort of the big banks and domestic cyclicals, but McCarthy cautions that such herding can be dangerous. 

"Investors buy names like CBA for reasons beyond its investment merits (e.g. hedging benchmark risk). This leads to excessive valuations like we see today, but what about tomorrow?"

Together, their views paint a clear picture: small caps are drawing fresh interest thanks to growth potential and attractive pricing, while large caps, though still the market's anchor, may be weighed down by crowded trades and stretched valuations. 

For investors, the divergence between the two segments could be where the next big opportunities merge. 

Valuations and earnings growth - value vs stability

The earnings gap between the market's giants and its rising stars is stark, and Donohue says it's one investors cannot ignore. While large caps may offer stability, their growth outlook looks muted:

"People might be surprised to learn that the expected earnings growth in the ASX200 for FY26 is basically zero. Small caps on the other hand are closer to 10%."

That differential, he argues, positions smaller companies as a rare source of genuine expansion in a market where the big names are largely treading water. 

McCarthy doesn't dispute the numbers, but urges caution before abandoning the blue chips entirely. Large caps may not be delivering headline-grabbing growth, but he sees selective opportunities for patient investors. 

"In the large cap universe, there are definitely opportunities, but there are also pockets of elevated valuations to avoid... We currently like global cyclicals and defensives, including ALL, CSL, COH, TWE, TLC, and WOR."

The message from both managers is clear: growth is tilted toward small caps, but stability and opportunity can still be found among the market's heavyweights - provided investors are disciplined enough to sidestep the crowded, overpriced trades. 

Risks - flying close to the sun vs macro dependency

For all their allure, the market's rising stars come with a unique set of hazards. Donohue is candid about their fragility:

"Smaller companies by their nature are always going to fly a little bit closer to the sun."

Among the biggest dangers is poor alignment between management and shareholders, "The risk of corporate insiders taking an outsized share of company gains is a key small-cap risk... Another risk is simply around the capital position of the company."

To mitigate this, Donohue's team scours balance sheets, evaluates debt levels, and scrutinises remuneration structures to ensure interests are aligned. 

McCarthy notes that size offers some protection - but not immunity. "Generally, larger companies have established business models and incumbent market positions. These attributes reduce risk and result in higher valuations."

But maturity brings its own vulnerabilities:

"Disruption could be caused by the risk of new entrants or substitute products... As companies become larger, the macro becomes a greater factor of growth; less so market share gains."

Together, their views highlight a trade-off: small caps may deliver outsized rewards but demand careful vetting, while large caps feel safer yet remain exposed to broader economic currents and disruptive challengers. 

Themes and sectors - innovation vs energy transition

Innovation has always been the playground of the market's rising stars, and Donohue sees small caps leading the charge once again. Their agility, he says, is their greatest weapon:

"Smaller companies tend to lead the market in these types of innovations given they can adapt and capitalise more quickly."

The hottest area right now? Artificial intelligence. "We’re definitely already seeing companies making clever use of AI in their existing workflow but – more importantly as far as opportunities go – companies exposed to AI megatrends coming to market. We’d expect some interesting deals/IPOs over the next 6 months or so."

On the large-cap side, McCarthy points to a different theme taking shape. While domestic cyclicals continue to act as safe havens for nervous investors, the longer-term story lies in energy.

"The energy transition is currently going through a bit of a consolidation phase. We think this is a good thing, as it will lead to more commercial and rational decisions when compared to the hype years and there remains a long runway for growth."

Together, their insights suggest opportunity exists at both ends of the market: nimble innovators shaping the future on one side, and heavyweight players positioning themselves for the next decade of energy investment on the other. 

Stock picks - ideas at both ends of the market

For investors looking beyond the headlines, both managers see compelling opportunities - albeit in very different corners of the market. 

Donhue singles out Integral Diagnostics (ASX: IDX) as a standout among small-cap healthcare names. He describes it as "a major market player within Australia’s resilient and growing radiology industry." 

Pointing to powerful structural tailwinds, "Factors driving these tailwinds are: Australia’s ageing population... and an ongoing mix shift that naturally tends to higher-priced services." With a stable industry backdrop and potential for margin expansion, Donohue believes IDX is poised to deliver strong returns. 

Another of his picks is Superloop (ASX: SLC), a telco challenger quietly reshaping the NBN reselling space. "Superloop delivered a strong result... continuing to take market share in the NBN reselling industry."

Yet the market reaction to Superloop’s FY25 result was counterintuitive:

"With continued execution on its key metrics and strong trading into early FY26, we’d have expected SLC to rally but instead it traded 16% lower through August... we’re happy to stay the course and see 30%+ upside on the stock."

For Donohue, such dislocations between fundamentals and sentiment are exactly where small-cap investors can gain an edge. 

Meanwhile, McCarthy is hunting among the large caps for value that the crowd has overlooked. He highlights Worley (ASX: WOR), a global engineering and energy services firm positioned for the long-term energy transition. 

"They have invested more in the quality of their staff and capabilities... and were quicker to reposition their business for the energy transition...We think it's very attractive at a P/E of 14x as its not pricing in the longer-term growth tailwinds."

McCarthy also names Challenger (ASX: CGF) as a mispriced opportunity. Regulatory shifts are turning a headwind into a tailwind, "Key tailwinds are APRA’s proposed change to capital requirements. This will reduce the market sensitivity of the business, and the higher rates will make long-term annuities more attractive."

Internally, Challenger is also gaining momentum, "There has also been evidence of product innovation... and good cost management. The risk reward profile is attractive as you have a stable base business underpinning the valuation, and a raft of growth opportunities that you are not paying for."

Among the large caps, Seek (ASX: SEK) stands out as a quiet transformation story. Under CEO Ian Narev, the jobs platform has been methodically reshaping itself for its next growth phase. McCarthy notes that investments in its core offering are already "leading to an increase in yield growth," while its placement share is trending upward as hiring markets stabilise. 

The company has tightened its belt on costs and streamlined operations: the sale of its LATAM businesses and the carve-out of early-stage ventures into a growth fund have left its balance sheet cleaner and more focused. 

Even job ad volumes, once inflated by the post-COVID hiring spide, have now normalised and are returning to growth. 

"We think Seek is well positioned to perform due to strong top line growth, outsized profit growth... and a clean set of financials," McCarthy says, suggesting the market may be underestimating the platform's renewed momentum. 

Together, these picks show how opportunities exist across the spectrum - whether it's nimble rising stars like Superloop and Integral Diagnostics or heavyweight defensive innovators like Worley, Challenger and Seek. The common thread is careful stock selection and a willingness to look past market noise to find underappreciated value. 

Final thoughts - balancing growth and stability

The recent rally in small caps suggests the pendulum may finally be swinging their way, but both managers caution against a one-sided bet. 

Donohue is unequivocal in his optimism, describing today's environment as 

"A pretty compelling opportunity at the smaller end of town. Don’t miss out!"

His view is that attractive valuations, stronger earnings growth, and renewed investor interest make small caps hard to ignore. 

McCarthy, however, warns that large caps still have a role to play - provided investors tread carefully. 

"In the large cap universe, there are definitely opportunities, but there are also pockets of elevated valuations to avoid," he says.

For him, disciplined selection among global cyclicals and defensives can deliver stability without overpaying for crowded trades. 

The takeaway? Growth and resilience both have a place in today's market. Stock picking - not index hugging - will determine who captures the next wave of outperformance. For investors willing to weigh nimble rising stars against dependable heavyweights, the smart money may lie in balancing both ends of the market. 

Managed Fund

Lennox Australian Small Companies Fund

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Managed Fund

Elston Australian Large Companies Fund

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