Where QVG is finding small cap Nirvana (hint: not in defence stocks)

A mixture of high volatility, declining bond yields and elevated valuations in large caps mean Australian small caps could be entering "investing Nirvana".  At least that is the view of QVG Capital's co-founder and portfolio manager, Tony Waters.

Over the past year, QVG has been taking advantage volatility, using sudden the sell off in the shares of specific companies to add new positions and reintroduce companies they like but previously sold due to valuation concerns, while avoiding segments that they believe look overheated. 

The result? A year where, according to co-founder and portfolio manager, Chris Prunty, there were far more "winners" than "sinners".

QVG Capital operates two funds – the QVG Opportunities Fund and the QVG Long Short Fund.

Both funds have had a very successful 12 months.

The Opportunities Fund – which is a concentrated portfolio built around ASX-listed small caps – returned 44.1% over the 12 months to 31 August 2025. This was 20.7% better than their benchmark, the S&P/ASX Small Ordinaries Accumulation Index which is a benchmark commonly used to reflect the performance of small cap companies.

QVG’s Long Short Fund – which looks to take advantage of the best ASX opportunities regardless of share price direction or market capitalisation – returned 22.0% during that time frame.

Although some may scream about such performance from the rooftops, Waters is taking a more cautious view explaining that “it’s not about having a big innings. It’s about the batting average. And consistent batting average over time”.

Using this measure, QVG can also be pleased with the Opportunities Fund outperforming its benchmark by 8.2% on a compounded annual growth basis since its inception in September 2017 and the Long Short Fund generating a compounded annual return of 17% since May 2019.

A volatile, but booming, time

QVG painted an interesting picture of current markets.

On the one side, you had an extremely volatile reporting season where any misses were treated harshly by the market. This was highlighted by the fact that around 46% of stocks saw their share prices move at least 5% on earnings compared to the long-run average of 27%.

On the other side QVG pointed to a “serene” bond market which has traded in a relatively low band around the mid-4% to low-4% range for the Aussie 10-year bond. This has led to a slow decline in a company’s cost of capital which has given the stock market a boost, particularly growth stocks which have benefitted from multiple accretion.

Is it time for small caps to shine?

For more than 3 years, the ASX Small Ordinaries has underperformed the ASX 100.

The view from QVG is that as interest rates started to rise in around 2022 and 2023, there was an outflow of funds from retail investors and increased popularity of index or passive strategies.

This has led to capital flowing into the larger end of the market which has pushed valuations of those companies higher versus small caps – which make up a much smaller portion of the market.

QVG, however, is starting to see this trend shift.

According to Waters:

“Typically, small caps are high beta in nature, you know, in a bull market, you’ll get better performance. In a bear market, you’ll get worse performance in small caps.”

This was echoed by Josh Clark, who is the portfolio manager of the QVG Long Short Fund.

“Employment is full, inflation’s coming down, and interest rates are coming down. So, really that is a supportive environment for equities. We’ve seen it in terms of performance in equity markets and even within equity markets, it’s been the high beta portion of those markets that have been performing well. So, small caps have been outperforming large caps”

With the current environment expected to be conducive to equity markets and a big valuation difference between large caps and small caps, QVG believes that there is still “some way to go in the small cap space in terms of outperformance”.

Beware the concept stock

QVG, however, isn’t universally bullish.

In the Long Short Fund, QVG targets three categories when looking for stocks to bet against.

These categories as those with earnings risk with financial leverage on the balance sheet, companies in structural earnings decline and what Clark calls “concept stocks” or stocks where the promises aren’t necessarily matched by the company’s income statement.

One segment or theme that QVG thinks falls into the concept stock segment is the defence sector. Over the past twelve months, ASX-listed defence stocks have (excuse the pun) rocketed upwards.

According to Josh Clark, there is at least some reason for the optimism:

“So, a lot of you would be aware of the geopolitical tensions out there at the moment. I guess one stat that’s interesting, I think, is that NATO countries have committed to take spending as a proportion of GDP from 2% to 5%. So, there’s definitely some truth behind that optimistic outlook.”

However, when Clark compares the 1-year return of ASX-listed defence stocks, many of them up by triple digits, to the forecasted free cash flow for these companies, estimated to be around negative $360 million, you see something vastly different.

“It’s not to say that these stocks can’t continue to go up or eventually be prosperous. But, when you are seeing 2% to 2.5% of enterprise value go out the door in cash, there’s really a high bar in terms of what those stocks need to do to justify their market caps.”

Blasts from the past

So, where has QVG found opportunities.

For starters, they are continuing to be picky.

Unlike other some other funds who cast a wide net, QVG instead likes to pay attention to a very small universe of stocks – as few as 70 -- that they believe offer the prospective level of quality and growth. They then filter this basket for value to find only around 25-30 companies which they believe warrant inclusion in their portfolio.

In the words of QVG cofounder and portfolio manager, Chris Prunty:

“Given the rally in the market, it’s becoming, with only a couple of exceptions, quite difficult to find outright statistical value, and sometimes when you do find it, we’re just as likely to find that they’re value traps and not value”.

They also keep a determined focus on the business and the numbers rather than market volatility.

In fact, recent market volatility has helped the fund add new positions.

“When stocks move 20% or 30% on the day of their results during reporting season, it’s very unlikely that you’re going to make a good incremental decision about that stock unless you’ve done the work ahead of time. So, being prepared has never been more important” says Chris Prunty.

Unsurprisingly, being prepared has meant that companies QVG already knew well, and previously owned, have provided many of the positions that the funds have gobbled up when market volatility offered the opportunity such as Guzman Y Gomez (ASX: GYG), Zip (ASX: ZIP) and Bravura (ASX: BVS).

Other new ideas include accommodation software platform, SiteMinder (ASX: SDR), payments company, IDP Education (ASX: IEL) and Singapore-based telecom company, Tuas (ASX: TUA).

QVG’s portfolio ended the period with a mix of high growth small caps and those that can be considered “growth at a reasonable price” or GARP, Aussie Broadband (ASX: ABB) being a good example of a GARP company the fund recently added to.

Such a portfolio is well placed to take advantage of what QVG believes could be a positive environment for small caps.

A replay of the webinar is available here.