Small cap companies have underperformed large caps over the past four years. Despite this, Wilson Asset Management’s WAM Capital (ASX: WAM), WAM Research (ASX: WAX) and WAM Microcap (ASX: WMI) have outperformed both large caps and small caps. The strong performance of small cap companies in the US following a rate cut illustrates how an expected rate cut the first half of 2025 can be a tailwind for Australian small caps.
Australian small caps have underperformed large caps by 8%pa in the past four years, presenting an opportunity for investors
It’s been a challenging period for small cap companies. Despite delivering a positive return of 16% in Australia, in the past four years to November 2024, their total return (income and capital growth) underperformed large caps by 8%pa in Australia, 6%pa globally and 5%pa in the US.
Does this underperformance suggest small caps are now undervalued, especially given company earnings have also declined? Yes, this is evident in the US and Australia. When looking at the Enterprise Value (EV) to Earnings Before Interest Taxes Depreciation & Amortisation (EBITDA) multiple* in the US, small caps (Russell 2000) are currently trading at a 6% premium to large caps (S&P 500), below its 20-year average of a 38% premium. Prior to 2021, it had not been this low since 2005.
In Australia, the EV/EBITDA multiple of small caps (S&P/ASX Small Ordinaries Index) relative to large caps (S&P/ASX 100) is tracking at a 24% premium, below its 20-year average of a 32% premium. A reversion back to historical average multiples would result in small cap share price outperformance.
Another way small caps can outperform is through earnings growth. We think a number of sectors within small caps that have struggled in a period of rising interest rates and cost of living pressures, such as retail, automotive, real estate investment trusts, building materials and media, will see an uplift in earnings and consequently share prices as interest rates decline. Consensus Earnings Per Share (EPS) growth in 2025 is forecasted to be 34% in the S&P/ASX Small Ordinaries Index compared to just 3% in the S&P/ASX 100. This means that even in an environment where valuation multiples, such as Price to Earnings, do not change, share prices should increase as earnings grow.
Despite the challenging environment for small caps, Wilson Asset Management’s proven investment process and active management in uncertain environments have delivered strong results across each of our small and mid-cap listed investment companies (LICs). The annualised four-year gross performance to November 2024 in WAM Capital, WAM Research and WAM Microcap of 12.6%, 16.1% and 11.7% respectively, has been above the S&P/ASX 100 of 10.7%. All LICs have also vastly outperformed the S&P/ASX Small Ordinaries Index of 4.3%pa and Small Industrials of 3.8%pa.
What’s driving the underperformance of small cap companies?
There are a few key reasons for the relative underperformance of small caps that could shift to become a tailwind in 2025, including interest rates, inflation, liquidity, capital markets activity and passive investing:
- Higher interest rates: As investors earn more sitting in cash investments (e.g. term deposits or bonds), they demand a higher return from equities. This has a disproportionate impact on high-growth companies compared to low-growth companies. Smaller companies, which typically carry higher leverage, also face increased interest costs compared to larger companies.
- Inflation: Smaller companies typically have less dominant market positions, lower profit margins, and less pricing power to pass on higher costs compared to larger companies.
- Liquidity: Small cap stocks are less liquid, meaning it’s harder for institutional investors to buy or sell large amounts of shares without affecting the price. In times of macroeconomic uncertainty, this liquidity issue often drives investors towards larger, more liquid companies. The reverse is true in a more predictable macro environment (lower inflation and steady interest rates).
- Slow capital markets activity: Higher interest rates increase the cost of raising debt or equity, which has an outsized impact on smaller companies that rely on capital for growth. So far in 2024, there’s been 21 Initial Public Offerings (IPOs) on the ASX compared to 30 in 2023 and 204 in 2021. Companies looking to IPO also prefer a more certain macro environment. 2025 should see an uptick in capital markets activity.
- Passive investing: Passive investing, including Index Funds and Exchange Traded Funds (ETFs), requires greater liquidity and has perpetuated the preference for large caps over small caps, particularly as it is momentum driven i.e. purchases more shares when the share price increases.
Where to from here? What the US rate cutting cycle illustrates
Since the market began pricing in an imminent interest rate cut in the US six months ago, US small caps (S&P 600) generated a total return of 17%, outperforming large caps by almost 6%. Inflows into small-cap ETFs in the US in the September quarter also increased to US$16.5 billion, almost double the total inflows over the prior two quarters of US$9.4 billion.
We forecast a Reserve Bank of Australia rate cut around March/April 2025, with additional rate cuts throughout the year. The strong performance of small cap companies in the US following a rate cut illustrates how it can be a tailwind for small caps in Australia.
Active management remains crucial in navigating these opportunities and, at Wilson Asset Management, we are focused on identifying undervalued small caps with a catalyst that can outperform as conditions improve.
*EV/EBITDA is a ratio used to assess a company’s value. It helps investors determine if a company is overvalued or undervalued compared to other companies and the market more broadly. It is a similar metric to Price to Earnings (PE) but is more focused on the operating business rather than its financing or accounting policies and choices (ITDA).
