By Tim Boreham

Despite the parlous geopolitical climate, market watchers are heralding the volatile and higher-risk small cap sector as the ‘it’ investment theme for 2024.

A key reason is the rising expectations of interest rates stabilising – and even falling – by the end of the year as the inflation demon is bought under control.

Cheaper finance helps the market overall, but is especially handy for smaller companies with weaker balance sheets. Lower rates also bolster disposable consumer income, with sentiment already improving among the smaller retailers.

Wilson Asset Management portfolio manager Tobias Yao predicts a “robust” year for the small ‘uns – if only because they have underperformed since 2021 and are due for a rebound.

Prominent fundie Roger Montgomery concurs: “Small caps can react very quickly when the narrative becomes positive and sentiment shifts.”

Since January 1, 2022, the small-ordinaries index has declined about 12 per cent, compared with a circa 10 per cent gain for the All-Ordinaries index.

The outperformance of 22 per cent is the most accentuated since the Global Financial Crisis – after which the small caps went on a tear.

On the flip side, the ASX 200 stocks look expensive, trading on an earnings multiple of 16 times compared with the historic average of 14.8 times.

The sunnier small-caps outlook has been evident since late October and has been especially notable among the smaller retailers.

Australian Bureau of Statistics showed record retail sales of $36.5 billion in November – the highest-ever reported and up 2.2 per cent year-on-year.

Likely small-cap furniture and homewares beneficiaries are Adairs (ASX:ADH), Nick Scali (ASX:NCK) and the online trader Temple & Webster (ASX:TPW).

Centennial Asset Management’s Michael Carmody likes the housing-exposed Beacon Lighting (ASX:BLX).

In the tech space, he nominates mining services provider RPM Global (ASX:RUL) and the obscure compliance house Ansarada (ASX:AND), which provides virtual data rooms for M&A participants to manage confidential information.

Of course, small caps are a large and ill-defined cohort, so selecting the right stocks is critical: the underfunded duds will remain so no matter how much fairy dust the central banks spread.

Yao conceded that avoiding the turkeys was “not as easy as it seems”.

To improve the odds of success, he looks for founder-led businesses of significant scale with strong organic growth and – of course – a healthy balance sheet.

“If you can tick these three boxes in the small cap space it is a very good starting point,” he said.

Yao cited Singapore telco Tuas (ASX:TUA), which was demerged from TPG Telecom after TPG merged with Vodafone Hutchinson Australia in 2020.

Visit Stockhead, where ASX small caps are big deals

The fastest-growing telco in the prosperous Lion City, Tuas has grown market share from zero to 10 per cent over four years by offering better value for money – the same formula major shareholder David Teoh used at TPG to snare 25 per cent of the Australian market.

Yao also is a fan of Temple & Webster, the biggest online retailer, enjoying the benefits of scale and AI initiatives to take share from traditional retailers in a fragmented market.

The third leg of the Tobias Trifecta is Regis Healthcare (ASX:REG), the only ASX-listed aged care provider after Estia Health was subsumed by Bain Capital last year.

“The sector has had a tough time with the Royal Commission into aged care and Covid,” Yao said. “Regis has had to deal with these challenges and is now thriving.”

Yao said the sector would benefit from baby boomers moving into aged care in large numbers, while smaller players were leaving the market because the compliance burdens were too great.

“Our view is you want to invest in the largest and most efficient operators in the sector.”

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