Superior earnings drive Aussie small caps rebound: Report

Improved earnings growth will drive an anticipated rebound in Aussie small caps stocks, a new white paper has argued, though investor gains will demand a selective approach.

With economies and supply chains ‘normalising’ post-Covid and interest rates falling, the report from Aussie boutique Prime Value forecasts improved growth (based on earnings per share) for local small caps over the medium-term, particularly relative to large caps peers.

Bloomberg data shows increasing optimism around listed small caps, with expectations of around 25% earnings growth over the next 12-24 months for firms on the ASX Small Ordinaries Index. This is substantially higher than the 10% growth forecast in early 2023.

It is worth remembering however that small cap companies, historically, generate stronger earnings growth than large caps – typically a function of their relatively smaller earnings base and market share.

As a result, “small improvements in market share [have] a more material impact on earnings growth [versus] larger companies,” the report authors wrote.

Nevertheless, they note, “consensus estimates once again forecast stronger EPS growth for small caps relative to large caps over the medium term”.

Relative to their larger peers, Australian small cap stock performance has been disappointing in recent years, underperforming large caps by 25% over the past three years, echoing figures seen in US small caps.

Active management matters

The small caps market is large and highly diversified, with a significantly larger and often less exposed universe of stocks for investors to consider.

For investors to capitalise on the emerging earnings strength of small caps companies, the Prime Value paper, Why Now is the Time to Invest in Listed Australian Small Companies, argues for an embrace of active management.

“Greater diversification allows managers to take a stronger conviction,” Prime Value wrote.

The investment manager compared the broader market impact of a large cap versus a small cap gainer.

“[A] 10% rise in BHP shares adds a very large 103bps to the large cap index return, and so has a large impact on a fund that doesn’t own a position.”

“By contrast, a 10% move in Life360 [the largest constituent in the small cap index] would add just 16bps to the small cap index’s performance … placing little pressure on small cap investors to own stocks they don’t necessarily have conviction in.”

For Prime Value, smaller companies also provide the opportunity to invest across a wider spectrum of the economy.

“A key argument for investing in small caps is the success active small cap managers have had in generating consistent alpha.

“This is a function of the relative inefficiencies in the small cap market, such as lower liquidity and less analyst coverage, combined with stronger earnings growth and a more fragmented index composition.”

As well, strong portfolio management can also help investors differentiate from the index and avoid investment mistakes in what is a more volatile segment, the firm wrote in its report.

“The dispersion of returns is much wider in small caps than in large cap stocks. While there are high-growth companies that deliver outsized returns, there are also companies that significantly underperform or fail altogether.

“Therefore, avoiding investment mistakes – particularly companies that experience large drawdowns – is a key attribute that can contribute to consistent long-term returns.”