The ASX small-cap rebound (plus 3 stocks to add to your watchlist)

After being weighed down by higher interest rates and cautious consumer spending, the small-cap comeback is underway. For small-cap investors, their resilience has been rewarded after the last few years of mid and large-cap dominance.

In a recent interview, Gary Merkel, portfolio manager at Elston, focusing on the Australian Emerging Leaders strategy, discusses why he thinks the small-cap segment is just at the beginning of its recovery, what sectors stand to benefit most from rate cuts, and why sticking to being true-to-label has been tough but rewarding. 

For all of the insights, watch the video above, or read the summary of the intervew below. 

Please note, this interview was recorded on Wednesday, 24th September 2025.

A small-cap redux

While geopolitics and trade tensions have been what's driving markets over the last six months, monetary policy has been a longer-term issue that has weighed heavily on the small-cap part of the market. Looking back over past periods of underperformance, Merkel notes that small caps often rebound strongly once conditions start to normalise.

"We've gone back and had a look at past cycles where you've had these prolonged periods of underperformance. And interestingly, there tends to be a pretty strong period of relative outperformance that follows these periods."

While early signs of outperformance are emerging, he believes it’s still “relatively early” in the cycle.

“If we combine that with thinking about the businesses in the small-cap segment from a bottom-up perspective, we think the valuations look reasonable. So, combining the two, we think there's a lot of opportunity within the small-cap market at the moment."

The rate cut effect

The RBA has already delivered two rate cuts this year, with markets expecting another in November. Merkel says the benefits are flowing through more quickly than expected. 

Retailers exposed to domestic demand reported a stronger-than-anticipated Q4, with momentum continuing into the new financial year.

He sees consumption, particularly among millennial cohorts hit hardest by the cost-of-living pressure, as the part of the market that could be “supercharged” as rates fall further.

Why sticking to small matters

While some managers have drifted into mid- and large-cap names in search of smoother returns, Merkel argues that “staying true to label” is essential.

“Our portfolio is a high-quality, high-conviction, small-cap portfolio, and we want our investors to get what they expect they're going to get,” Merkel says.

Straying up the market-cap spectrum risks unintended overlap in investors’ broader portfolios and dilutes the potential to capture alpha where fewer managers operate.

While “it would've been a far easier ride if we had parked money in the mids or large over the last three to five years,” Merkel points to performance generated within the segment as proof that the discipline works over time.

Managing risk in a volatile segment

Small caps are perceived as riskier, and Merkel acknowledges, “I'd be lying if I said it wasn't stressful.” However, he also emphasises the importance of capitalising on the opportunities that volatility can create.

“That's where you get big dislocations in intrinsic values. So although it's stressful, it's times like that where you need to have your eyes wide open and be ready to pounce because you might find that entry value into something that could really make the fund over the next five years.”

But risk management, he says, starts with an evidence-based process, and balance sheets.

His team avoids businesses carrying significant debt, pointing to research across two decades of failures that found that companies with significant amounts of debt was the common thread.

From there, Merkel says, portfolio construction tilts towards higher-quality, more durable businesses. 

"If you combine the two, only investing in businesses that have strong balance sheets and then re-weighting within the portfolio to the more durable businesses, that's the way we look to try to mitigate downside risk."

Lessons from two small-cap stock stories

Merkel highlights two stocks that underscore the short-termism within the small-cap segment of the market, which was particularly apparent in the most recent results season, resulting in divergent outcomes across different companies.

• Baby Bunting (ASX: BBN): The retailer’s turnaround under new CEO Mark Teperson has been well received. Early data points from refurbished stores and a new shop format trial saw the share price nearly double in recent months.
  

• Audinate (ASX: AD8): While guidance was softer than expected, the bigger issue was management’s decision to reinvest aggressively in software development. The market sold off sharply, but Merkel argues the long-term competitive moat remains intact and that reinvestment could ultimately entrench its position.

Portfolio moves: exits and quiet compounders

After years of delivering excellent returns for the fund, the team recently exited Hub24 (ASX: HUB) as it entered the ASX 100, as consistent with their mandate to remain focused on genuine small caps. 

On the other side, Merkel says they have been adding to positions like XRF Scientific (ASX: XRF), a Perth-based business dominating niche markets in sample preparation consumables and equipment, who "have a knack of being able to find new market segments and bring products that are a good fit." Merkel sees it as a quality compounder quietly building out sales and earnings.

Risks and opportunities ahead

Domestically, consumer conditions are improving, with inflation and unemployment risks moderating. "We're seeing some green shoots, particularly from the consumer. So we're starting to get a little bit more comfortable with those risks domestically," says Merkel.

The greater concern lies in the rapid acceleration of technological change. Merkel says the portfolio is being closely reviewed to ensure holdings aren’t blindsided by disruption and the significant leaps that are potentially going to occur over the coming years.

Looking five years out, Merkel remains constructive on small caps, expecting strong EPS growth despite macro uncertainty.

“As a small-cap investor, there's always an opportunity. We have so many businesses to choose from, so we can be very selective. There's many stones to turn over to find hidden gems as we like to say. So the opportunity is there regardless of the market cycle."

Managed Fund

Elston Australian Emerging Leaders Fund

Australian Shares

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