Improving dynamics for Small Caps in the Australian Equity Market

From December 2021 until 31 August 2023, Large Cap stocks (ASX100) have outperformed Small Cap stocks (ASX Small Ords) by 14.6% p.a. More recently, JANA has noticed a positive change in investor sentiment towards Small Caps which has coincided with an improved outlook for Small Cap earnings relative to ASX100.

The performance differential between Large Caps and Small Caps has been driven by several factors. Consensus earnings expectations for Small Caps were revised lower from mid-2022 on the back of weakening economic outlook, company specific factors and weakening market sentiment. Through that period, investors traded out of Small Caps into Large Caps for greater earnings certainty.

JANA has recently downgraded our view on Australian equities based on a weak fundamental outlook, within Large Caps, which is not yet fully reflected in valuations but clearer in sentiment.

Fundamental Expectations

The consensus earnings expectations for the ASX 100 has deteriorated since February 2023 and this has intensified leading into the August 2023 reporting season. Over the same period, consensus earnings growth for ASX Small Ords has held up.

The earnings outlook for Large Caps is facing headwinds which are largely driven by the outlook for Financials and Materials which represent 55% of the ASX100 index:

• Major Bank margins are currently under pressure due to increased market competition, rising cost of funding and slowing credit growth. Small Cap financials are largely wealth managers and platform operators such as NetWealth which are not subject to these pressures.
• Major Miners face the headwind of falling commodity prices on the back of slowing global growth driven by China. Small Cap Miners are more diverse from a revenue perspective and more exposed to ‘transition’ materials which have longer term structural demand support such as copper, gold and lithium (used as inputs to processes such as manufacturing electric vehicles).

Sentiment towards Small Caps

JANA regularly surveys investment managers to gauge sentiment in the market. The results of our most recent survey suggest that sentiment towards Small Cap stocks is more positive relative to Large Cap stocks.

• Managers broadly view the opportunity set for Australian equities as being Average, and managers with a Below Average view outnumbering those with an Above Average view 2:1.
• Nearly two thirds of managers view the outlook for Small Caps as being Above Average. Of the remainder, managers who assess the outlook for Small Caps as being Below Average are outnumbered by those who view it as being Average by 3:2.

This positive market sentiment for Small Caps is likely to provide support for prices of Small Cap companies in the medium term as active managers allocate capital to the market cap segment.

The weakening fund manager sentiment towards Large Caps is also evidenced by a general underweight towards the Banks and Miners, elevated levels of cash (see chart below) and overweight Staples, Health Care, and Industrials.

Active Management

In addition to the earnings and sentiment factors above which are pointing towards a favourable current environment for Small Caps relative to Large Caps, we believe that there are greater opportunities for investment managers to systematically add value in the Small Cap segment of the market compared to the Large Cap segment.

• The Large Cap segment is more efficiently priced as there are more investors analysing and trading on information in this part of the market. This includes overseas institutions trying to get exposure to the Australian markets.
• There are many low-quality companies in the Small Cap segment with poor cash flows and balance sheet management which tend to underperform. The level of skill required for active managers to identify and avoid these companies is lower, and we have observed that alpha is therefore often easier to come by for Small Cap managers relative to Large Cap managers when compared to their respective indexes.

The chart below, taken from the eVestment universe of Australian Small Cap managers, shows that most Australian Small Cap managers have delivered strong outperformance (gross of fees and taxes) relative to the Small Cap index. For investors with a dedicated allocation to Small Caps, the alpha that most managers have generated over the past three years would have offset some of the underperformance from a beta perspective between ASX100 vs ASX Small Ords.

Conclusions

From an asset allocation perspective, JANA has maintained a preference for an active exposure to Small Caps given the Small Cap market often exhibits unique inefficiencies making its more conducive for active management.

From a present market perspective, JANA has observed a positive change in investor sentiment towards Small Caps along with a moderating decline in consensus earnings revisions for ASX Small Ords relative to the broader market.

JANA is not advising clients to allocate additional exposure to Small Caps now but rather we are observing a potential positive trend towards Small Caps after an extended period of relative underperformance compared to Large Cap.

Please reach out to your consultant if you are interested in discussing further opportunities for your portfolio in the Australian Small Cap space.