Small cap investors finally getting the returns they deserve

The last couple of years have been a tough time for those who love the challenge and potential high returns from investing in the small cap space.

Even with great research in identifying terrific small companies with a great future, the share market has been rewarding size over substance, with the large cap space rising more strongly than fundamental analysis would suggest.

The good news is that the tide has now turned, with some of the so-called “magnificent seven” enormous technology growth stocks in the US (Meta, Microsoft, Tesla, Alphabet, Amazon, Nvidia and Apple) starting to show some performance cracks.

At the same time, the small cap space both here in Australia and overseas is finally showing some signs of solid growth as investors finally begin to appreciate the superior value and growth available in the relatively unloved small cap universe.

Small caps starting to outperform

Since October last year, the Small Ords is up 15% compared to 11% for the ASX 200.

Some of that outperformance might be due to the now increasingly unlikely prospect of lower official interest rates but nevertheless, it is a solid indicator that investors are starting to take a more clear-eyed look at smaller companies and are finding lots of value there.

As Monash Investor’s Shane Fitzgerald put it in an interview with Livewire: “Investors’ willingness to go down the risk curve is heightened because now that inflation is tamed, the large caps go back to being their boring old selves.”

“Now, we’re in an environment where quality growth will do well – and you can find a lot more quality growth in the small-cap space than in large caps,” he said.

It is a sentiment strongly echoed by fellow small cap researcher ICE Investors, whose flagship ICE Fund is distributed by SG Hiscock & Company.

Opportunity still open for new investors

A recent research paper by ICE research found that the opportunity for quality small companies to outperform large cap stocks is largely intact, even after gaining in value in recent times.

That is because of the size of the gap that opened up as the value of the large caps rose strongly and the size of that opportunity is even greater when screening for higher quality small caps.

ICE Investors’ do this by using the ASX Small Industrials Index as the control group and then identifying companies as ‘strong franchises’, ‘solid franchises’, ‘typical company’, ‘below average company’ and ‘challenged and/ or loss-making’ companies.

This analysis shows that about half of the Smaller Industrials index consists of higher quality companies, with these higher quality companies having better earnings growth, slightly lower debt levels and similar profit margins compared to the top 100 companies.

Obviously, these are the companies ICE and individual investors want to invest in, subject to the valuations being good.

The research compared the median price earnings ratio for the Strong Franchises and Solid Franchise categories and compared it to the Top 100, which showed that some of the most attractive valuations on offer in the small cap space are for the second tier ‘solid franchise’ businesses, with their valuations attractive relative to large caps and also their own history.

Time to be more selective

Shane Fitzgerald of Monash Investors also thinks there is more upside ahead for ASX small caps but it is a time to be more selective.

“I think there’s still plenty of upside and that’s going to be driven by earnings growth. We’ve probably seen most of the multiple expansion part of it, that blanket multiple growth with no earnings associated with it,” Fitzgerald says.

He points to stocks such as Life360 (ASX: 360) as an example of a small company that has been positively re-rated.

“In these sorts of names, that multiple expansion has probably run its course. Now they need to execute on their ambitions to deliver next-level growth, and they can certainly do that,” Fitzgerald said.

“This is an environment where the underlying performance of companies can come to the fore and as always, the challenge for investment managers across the board and investors in the market is identifying those companies that are going to do well.”