The best year since the GFC? These experts are ready to go big on ASX small caps this year

Stockhead 7Jan24

• -Brown Abbott reckons 2024 could be the best year for small caps since the GFC
• Ophir Asset Management says small cap valuations are the cheapest they’ve been in 15 or 20 years
• Red Leaf Securities says ‘2024 will be the year of the small cap recovery’ after two tough years 

Despite somewhat of a sluggish start to 2024, fund managers and analysts are optimistic for equity markets, particularly the smaller end of town.

Portfolio managers at Maple-Brown Abbott reckon with inflation looking like peaking and an end to the rate hiking cycle of central banks in sight, 2024 has a shot at being the best year for small caps since the Global Financial Crisis.

“We believe the Australian small caps market is at an inflection point given the more favourable macro-economic backdrop and expected earnings trajectory,” says Australian small companies co-portfolio manager Phillip Hudak.

“With a lot of negative sentiment priced in to Australian small companies, and signs that financial conditions are easing, inflation is moderating and interest rate rates have peaked, we believe we are seeing one of the most favourable environments for the Australian small caps market to outperform in 2024 since the global financial crisis.”

Australian small companies co-portfolio manager Matt Griffin agrees and points to key themes that may emerge in small caps in 2024.

Outsized underperformance of small caps set to end

According to S&P Dow Jones Indices the S&P ASX 200 benchmark finished 2023 with a gain of 12%, closing just 0.3% away from a record high.

The S&P ASX Small Ordinaries finished 2023 up 7.82%, the S&P ASX Mid Cap 50 rose 7.76%, while the S&P ASX Emerging Companies index was just short of ending 2023 in positive territory, finishing down 0.36%.

Ophir Asset Management specialises in small and mid cap equities investing both in Australia and globally. Head of research Luke McMillan says the last two years has been a “really torrid time” for small cap investors both in Australia and globally.

“You have to go back really a number of decades to see things be as bad as they’ve been for small cap investors and of course the precipitating factor was this rapid increase in interest rates,” he says.

“That hit longer duration assets like longer duration bonds and when you’re talking about the equity market pretty much the longest duration assets are small cap growth orientated companies.”

McMillan says this rate hiking cycle has hit small caps particularly hard with the underperformance of small caps versus larges caps in the US and Australia around 20%.

He says while the S&P 500 and even Aussie large caps are making all time highs, the small cap variant which is the Russell 2000 in the US and S&P ASX Small Ordinaries, are still both down about 20% from their highs.

“Historically, it’s really rare to see that bigger difference and normally even if we look at the worst part of business cycles which is recessions typically small caps underperform large caps by around about 5% on average,” he says.

“So even though we haven’t had a recession this time you’ve still got this outsized underperformance of small caps which is bigger than any recessionary period going back the last five or six recessions in the US.”

However, McMillan says the good news for small cap investors is it looks like central banks in key advanced economies are largely done with hiking rates.

“If you believe market pricing they’re all done hiking rates now there might be a little bit of residual risk, we might have one more in some regions, but on the balance of probabilities it looks like they’re done,” he says.

“Also we seem to have peaked out in terms of long term interest rates in those advanced economies so that big headwind for valuations looks like it’s largely done slamming into small caps over the head.”

Cheap valuations for small caps present opportunities

McMillan says further good news is we’re now starting from cheap valuations with small caps on an absolute and relative basis compared to large caps.

“We’re seeing valuations the cheapest they’ve been in at least 15 or 20 years, ” he says.

Furthermore, he says higher wages growth – also a headwind for smaller caps – appears to be stabilising.

“Smaller cap companies seem to have a higher proportion of their costs in wages and just like inflation has been coming down it looks like we’ve seen a peak in wages growth as well, so that is another good news story heading into this year,” he says.

However, McMillan says the residual risk is that while markets tended to rally in the last couple of months of 2023 on a higher probability of a soft landing and no recession in the US and Australia, we are “not out of the woods” with that probability still elevated.

“If we do get a recession there is undoubtedly will be more downsize for equity markets, including small caps,” he says.

McMillan says normally small caps do fall more than larger caps in a recession but it seems to be small caps have this time priced probability of a recession higher than large caps.

“In fact particularly if we look at the US even if we consider that bear case and do get a recession we may actually see small caps not fall as much as large caps because they seem to be pricing it more and are much cheaper,” he says.

“The last time we saw a recession where small caps didn’t fall as much as large caps was back in the dot.com bubble associated recession.

“It had similar characteristics where large were a lot more expensive than small caps so they fell more.”

Money to trickle back to small caps

Last week an unexpectedly high inflation reading in the US sent jitters through markets. Consumer prices in the US picked up again in December to 3.4% (from 3.1% in November), driven by increases in costs for housing, dining out and car insurance.

McMillan says it may be a bumpy ride still with work to firmly control inflation in the US and elsewhere but if it can continue to decline without much of an uptick in unemployment and no recession, then it’s likely we’ve seen the lows for equity markets.

“This liquidity discount where people are taking money out of small caps and hiding in large caps you’ll start see that money start to trickle back down the market cap spectrum’ we think’ and have that catch-up period of out performance for small caps,” he says.

McMillan says usually its part-way through a recession the market looks ahead to earnings recovery and will tend to recover before a recession is over.

“Then you will get the period of small cap catch up or outperformance of large caps,” he says.

“The average recession tends to go for nine to 10 months and this might be a milder one, more like the six-month variety, and the market starts rallying partway through.”

2024 the year for small cap recovery

Red Leaf Securities CEO John Athanasiou told Stockhead he is confident of a positive year for ASX and global small caps.

“2024 will be the year of the small cap recovery,” he says.

“After two tough years for the sector due to in a rising cash rate environment, small caps are poised to recover as cash rates start falling which reduces the cost of financing which in turn increases investors risk appetite.

“It is perfect conditions for a small cap recovery.”

Disclosure: The author held units in the Ophir Global High Conviction Fund at the time of writing this article. 

The views, information, or opinions expressed in the interview in this article are solely those of the interviewee and do not represent the views of Stockhead. Stockhead has not provided, endorsed or otherwise assumed responsibility for any financial product advice contained in this article.

I wouldn't base any investment decisions on this, but found it interesting nonetheless. Hopefully a similar pattern holds true on our market.

From Charlie Bilello twitter account:

The S&P 500 closed at an all-time high last Friday while the Russell 2000 Small Cap Index was still in a 20.4% drawdown. That's the largest Russell 2000 drawdown we've ever seen with the S&P 500 at an all-time high.

What happened following the 3 previous largest Russell 2000 drawdowns when the S&P 500 was at a record high? Both indices would rally higher over the next year with the R2k outperforming and joining the S&P 500 at an all-time high...

1) April 7, 1999 (-19.2% R2k Drawdown): S&P 500 gained 14.3% over the next year and R2k gained 36.5%.

2) February 13, 1991 (-13.5% R2k Drawdown): S&P 500 gained 12.1% over the next year and R2k gained 35.5%.

3) January 21, 1985 (-13.3% R2k Drawdown): S&P 500 gained 17.4% over the next year and R2k gained 18.2%.

In todays AFR ...

Fund managers ready for a big year in small caps

https://www.afr.com/markets/equity-markets/fund-managers-ready-for-a-big-year-in-small-caps-20231221-p5esze

and for those outside the paywall ...

Small-cap fund managers are starting to get excited.

After two years of trailing their large-cap peers, there are signs of life in the less liquid part of the market as investors have piled into the space in the last two months, sending the ASX Small Ordinaries Index up 13 per cent.

In the US, the gains are even more pronounced over the same period, with the Russell 2000 Index soaring more than 20 per cent.

The US Federal Reserve’s unexpected pivot on monetary policy this month has helped, turbocharging a broad rally that sent the major bourses at or near record highs as chairman Jerome Powell revealed that rate increases were “not the base case any more”.

War-weary fund managers say 2024 could be the making of small caps after a rough two years battered by the fastest global monetary tightening in a generation and fears of a recession that, as yet, has failed to materialise.

“I’m optimistic on small caps going into 2024,” Chris Prunty, founder of QVG Capital, tells AFR Weekend. “Then again, I was optimistic going into 2022 and 2023, and look how that turned out.

“[But] there are signs of life in small caps. For the year to October, the small-cap benchmark was down 6 per cent, but since then, the market has improved.”

Best conditions since GFC

The Small Ordinaries Index looks set to finish the year up at least 4 per cent versus an 8 per cent gain for the S&P/ASX 200. It’s a marked improvement on 2022, when a brutal equities rout sent the gauge tumbling 21 per cent, versus a 5.5 per cent retreat for larger stocks.

In an environment of rising interest rates, small-cap stocks typically don’t fare well as investors seek the safety of large liquid companies such as banks and miners. But that appears to be changing as traders price in about six rate reductions in the US and at least two in Australia in 2024.

“We believe we are seeing one of the most favourable environments for the Australian small-caps market to outperform into 2024 since the global financial crisis,” says Maple-Brown Abbott’s Phillip Hudak.

“A lot of the negative outlook is already priced in for Australian small companies. In addition, there are signs that financial conditions are easing, with inflation moderating and interest rates have peaked.”

Managers from Maple-Brown Abbott to Regal Funds Management and Eley Griffiths also say the balance sheets of many smaller companies are in good shape, with many debt-free and boasting “remarkably resilient” earnings.

“[Small caps] continue to confound fears of far more negative revisions in the face of higher interest rates, weaker demand, and cost inflation,” Mr Hudak says. “Many of these headwinds are expected to ease into the new year.”

And he’s not alone. Bank of America’s long-running global survey of fund managers shows a net 5 per cent of the 254 respondents who oversee $904 billion in assets expect large-cap stocks to outperform small caps, the lowest reading since June 2021.

Eley Griffiths’ David Allingham says a peak in bond yields and a marked easing in liquidity this month supports the case that, “at the very least, small-cap underperformance has finished”.

“This is positive as there is a significant mean reversion opportunity for small caps to play catch-up relative to large caps ... the question is, how long investors have to wait for this to eventuate?

“The prospects are good for small caps to outperform, but most importantly for investors looking at the space, it is highly unlikely that small caps will underperform.”

As for where fund managers are investing, they see opportunities from gaming to money management, as well as early IPOs. Here are eight stock picks for 2024.

James Sioud, Regal Funds Management

“We are bullish on Domain, with the stock likely to benefit from falling interest rates – as a long duration growth stock – but also as a beneficiary of increased turnover in the housing market.

“Since 2022 Domain has fallen 40 per cent whilst REA Group has risen 5 per cent, a stark contrast to the very strong correlation between the two stocks over prior years, and illustrative of this market’s preference for large caps. We think this historic performance gap is poised to close.”

Phillip Hudak, Maple-Brown Abbott

”GQG Partners is leveraged to more favourable markets and a recovery in global fund management flows. It offers earnings momentum as evidenced by consistent positive net inflows, stable fee margins, disciplined expense growth, strong distribution franchise and a robust balance sheet. The company trades at a material discount to both domestic and international fund management peers with an attractive dividend yield on offer.”

Martin Hickson, 1851 Capital

“Our largest position is Light & Wonder. They are one of the top three developers of content and hardware for the gaming industry and are competitive to Aristocrat. Around three years ago, Aristocrat’s ex-CEO and ex-CFO joined the company and brought around 80 of the team with them.

“Market share in Australia has gone from around 8 per cent two years ago to around 30 per cent today. That’s partly been driven by one of these new games, Dragon Train, currently ranked [a top] poker machine game in NSW and Queensland. It’s got the potential to enter the ASX 100, and trades on attractive multiples.”

Chris Prunty, QVG Capital

“We like insurance builder and disaster recovery company Johns Lyng Group. The stock is down 5 per cent this year despite our earnings expectations moving up over the past 12 months. We think next year’s earnings expectations are modest, and the valuation is compelling for a company with such a strong track record of earnings growth.”

David Allingham, Eley Griffiths

“A key pick for us is SiteMinder, which is hitting a free cash flow inflection point in 2024 and is in the early stages of accelerating monetisation of its existing global customer base.”

Simon Brown, Tribeca

Qualitas IPO’d in December 2021. It’s an alternative credit fund manager that raises funds from investors to be deployed into real estate lending. The alternative lending sector has been growing rapidly for the past five to 10 years as major banks have been retreating from lending to the sector, leaving opportunities for smaller players.

“Since listing, Qualitas has grown its assets under management by 90 per cent to $8 billion, and management forecast this growth to continue, with a recently provided FY28 AUM target of $18 billion.”

Alex Shevelev, Forager

“RPMGlobal is the largest investment in the fund. The company provides software to miners and mining services businesses. Many of the products are industry standard and key to the operations of a mine site, so very few clients stop using the products. The business is run by an aligned management team, has net cash on the balance sheet, and has been continuously buying back shares.

“Last year, revenue grew by 18 per cent, while profits more than tripled as the business showed excellent cost control. So far this year, RPM has upgraded earnings expectations twice and is on track to deliver another year of strong operating leverage.”

Damon Callaghan, ECP Asset Management

“A notable company to watch is Hub24, a leading wealth platform used by Australian financial advisers, which has plans to reduce inefficiencies in typical financial adviser workflows. Advisers, burdened with extensive administrative tasks, have less time for their core functions, like meeting new and existing clients. So, Hub24 employs its proprietary machine learning tools to organise data and develop automation solutions. Such innovations could prove transformative for clients.”

This article popped up on Livewire in the past day "20 stocks primed for the ASX small cap resurgence" with the byline "They've been pushed to the back burner for many, which is precisely why now is the time to consider small-caps, say these portfolio managers"

Tho the part I found interesting wasn't so much the stocks mentioned, nor the fund managers spruiking the potential resurgence in small cap land. It was the detail coming from the Longwave fund indicating they have 115 holdings in their portfolio, which seems to me to be a fairly contrarian view, and why they have such a diversified portfolio and why they believe it can perform better than a more concentrated/high conviction portfolio