Why small caps can (and will) outperform again

Examples include:

Source: S&P data, Seneca Financial Solutions

These sorts of winners, on average, outperform by +13% in the year after being included in the ASX 100.

Companies that are included in the Small Ords also include those companies that fall from the ASX 100. Based on our analysis, companies that drop out of the ASX100 as a result of what we define as “Structural Decline” on average, underperform by -9%.

Inclusions in the Small Ordinaries are also often problematic. Those names that enter the index without revenue, on average, underperform by -11%.

In summary, the composition of the Small Ordinaries Index makes it pre-disposed to apparent underperformance, relative to other Large Cap indices.

Time-series data can be misleading

Leithner predicates his analysis that small caps underperform over short, medium and long terms since 2004. Of course, returns are a function of both the start and end points selected and depending on the time period selected, data can be manipulated to support almost any narrative.

Small caps' recent underperformance (end point = today) makes returns look weaker across all previous time periods, whether it be 1 year, 3 years, 5 years, or 20 years. It’s only really the 24 months or so where returns have diverged and made the per annum returns look worse across all time horizons. You can see this clearly when visually represented.

What’s been the cause of this recent underperformance?

Inflation

Small companies generally don't hold up well during inflationary periods. By definition, they are companies that do not hold dominant market positions and/or established brands and as a result, have difficulty passing on price increases to offset rising costs, relative to their larger, more established counterparts inside the ASX 100.

Consequently, small-cap valuations correlate well with bond prices (which are a good 'live' inflation proxy).

Index Breadth

The underperformance, relative to the ASX 100 can also be explained by market breadth. 49% of the ASX 100 is concentrated in the top 10 names, four of which are banks and two of which are iron-ore miners. In fact, BHP’s share price alone is 84% correlated and has an R-squared of 0.70 with the underperformance of the Small Cap index relative to the top 100.

Compare this to the diversity found across the Small Ordinaries index and it’s easy to see why periods of strong commodity prices (as we’ve recently had) asymmetrically skew returns in favour of large Australian companies.

This higher degree of market breadth is not all bad news. In fact, it is music to active manager ears! Add in lower levels of analyst broker coverage, some liquidity challenges and a general malaise towards the sector from financial advisers and retail punters alike, creating goldilocks conditions to hunt outperformance. 

We analysed 97 Australian Small Cap fund managers to 30 June 2023 and found top quartile funds have outperformed the Small Ordinaries by an average of a whopping 8.0% pa over the past five years, after fees. Even more surprising is the bottom quartile manager, on average, only underperformed by -0.7% pa.

All of which says that you could have invested with almost any active, Australian small cap fund manager over the past five years and outperformed an equivalent ETF on an after fees basis.

It’s also interesting to note that the only real difference between a top and bottom-quartile Australian small cap fund manager is:

1. Approximately one more negative month a year; and
2. How much they make when the market is hot (max gain).

Everyone loses about 30% when the drawdowns occur, everyone bears similar volatility.

WHEN to buy small caps?

Now.

We expect small caps will close the gap to their larger counterparts, as smaller companies tend to outperform most when coming out of bear markets, with higher operating leverage to an economic recovery and rising GDP growth. History shows that this theory has worked in practice, with smalls offering significantly better returns bouncing off the economic bottom. 

This theory is supported by valuation. Whether we consider the Small Ordinaries cohort on a forward PE or EV/EBITDA basis, the smaller end of the market looks great value relative to recent history. 

Small caps = lower quality?

A common misconception is that buying small cap ASX shares is more akin to gambling than investing. While that may be true for many of the lower-quality microcap shares, remember that there is a far greater breadth of opportunities relative to large cap land and there are in fact many high-quality, profitable, small and mid-caps that are likely to be the success stories of tomorrow (and the shares you’ll probably kick yourself in the future for not owning today!)

As an example of what can be achieved, our particular portfolio of small companies is significantly more concentrated in higher quality businesses relative to the index and as such, we fully expect it to deliver outperformance in a range of potential market environments.

Conclusions

Australian small companies are, right now, the gift horse you're looking in the mouth. We (and everyone else in the market) appreciate that historical returns, at an index level, have been sub-par. However, as we’ve explained, the benchmark is relatively handicapped, active managers have materially and sustainably outperformed and you can build a portfolio of high-quality small companies without speculating on drill hole results or FDA approvals.

Supported by almost ‘as good as it gets’ valuations and with leverage to improving economic and operating conditions, making an allocation to one of the exceptional Australian, active, small cap managers should serve investors well over the next few years.