Investing in the next generation: Why quality small caps offer compelling returns

Investing in high-quality small companies can offer investors significant potential for upside, driven by the capacity of smaller firms to evolve into the large companies of tomorrow. While challenges remain, green shoots are emerging in various sectors, including the potential for more interest rate cuts in Australia.

In terms of valuations, small ordinaries are trading at fair levels, close to their historical average. Small companies are also trading at similar 2025-26 multiples to the ASX100 index, despite significantly higher expected earnings per share (EPS) growth of approximately 17% compared to the ASX100 at 7%.

While valuations are important, the real excitement for investors lies in the growth potential of small caps. We believe that small companies could be in a position to outperform large caps at this point in the cycle. The current market settings are particularly favourable for Australian small companies to outperform their larger counterparts, and a key factor is the commencement of an interest rate easing cycle by the Reserve Bank of Australia (RBA).

Periods of declining interest rates are often linked to strong outperformance by small-cap stocks. A good example to reference is the RBA's easing cycle in 2015, which exhibited similar settings to what we are observing today, supported by strong labour markets and slowing inflation. The 2015 easing cycle saw the ASX Small Ordinaries index perform strongly, posting a total return of 24.8% over 18 months-well above the ASX100's 3.9% return. This underscores the potential benefits for small caps in a low-interest-rate environment. Lower rates typically boost investor confidence and stimulate cyclical demand, which can be particularly advantageous for growing companies, many of which will also enjoy lower debt service costs.

Reporting season reveals positives

Many quality small Australian companies have solid foundations on which to build. Company results in the recent reporting season generally exceeded expectations, with margin resilience being a particularly prominent feature. This resilience, especially within ASX300 Industrials companies, appears to have been a significant driver of these positive results, which buoyed some companies share prices.

Still, the reporting season was volatile, characterised by substantial share price swings on result day. We witnessed unprecedented share price movements, with the average result day share price change of more than 7%, a historical high. This volatility underscores the importance of active management and a focus on fundamentals, as market sentiment can shift rapidly driving mispricing, and offering attractive opportunities for patient capital.

Taking a long-term view of potential opportunities is crucial. While the consensus forecast for FY25 earnings per share (EPS) continues its downward trajectory, there is anticipation of a turnaround in the 2025-26 financial year, with cyclical sectors expected to see improved EPS growth. However, the ongoing downgrade cycle for FY25 suggests a cautious approach is necessary, especially given Trump's tariffs and the risk of a potential trade war. The bifurcation across the economy continues, where socio-demographics have greatly influence recent spending patterns. For instance, mortgagees have been more severely impacted by cost-of-living pressure compared with the youth and retirees, as mentioned in CBA's Half Year Results Presentation Pack 2025. The resulting impact on various sectors underscores the importance of a detailed, bottom-up investment strategy.

Another positive factor is the broadening out of market leadership, which suggests a more distributed index performance, rather than the majority of returns being concentrated solely in the largest companies, as we have seen in the US. Examining sector-specific trends continues to point to a soft consumer environment, although green shoots are emerging, with the potential for recovery. Interestingly, essential services have appeared less defensive this cycle, as the economic pressures finally forced consumer downtrading behaviour and some volume losses across historically resilient sectors such as telecommunications and healthcare.

Separately, the impact of artificial intelligence (AI) is also starting to become evident, with some companies reporting material cost savings through AI implementation in areas such as customer support. In particular, we have seen that AI cost savings are starting to materialise and in many cases leading to significant cost avoidance and margin improvement, with companies such as Temple & Webster, HUB24, and NIB all reaping the benefits of AI implementation.

The potential for greater mergers and acquisitions (M&A) is also a developing theme, and we could see increased corporate activity in 2025, with the weaker Australian dollar making local companies attractive to offshore buyers, a trend that appears to be accelerating. However, initial public offerings (IPOs) activity remains relatively subdued and unaided by recently market volatility. In the real estate sector, there are indications that values have troughed, and capital flows are increasing, pointing towards a stabilisation and a potential positive inflection point.

Portfolio benefits of small caps

Adding small companies to a portfolio can have a range of benefits beyond performance. Small caps are generally more diverse in nature than large caps, which in Australia are dominated by banks and miners. Small caps generally reflects a wider cross section of the economy and often provides unique exposure to local growth and innovation.

A fundamental approach to identifying these good investments involves a thorough evaluation of earnings quality, focusing on businesses with consistent and predictable income streams.

Emphasis should also be placed on business quality, with a focus on strong business models, clear competitive advantages, and favourable tailwinds within expanding markets. Additionally, management quality is critical especially in small caps, with a preference for experienced leadership teams with proven track records that are aligned with the company's long-term goals.

The assessment of environmental, social, and governance (ESG) factors is also an integral part of the evaluation, considering both ESG risks and opportunities, and their impact on valuation. Such a comprehensive analysis aims to identify companies with more stable earnings, enhanced resilience to market fluctuations, robust downside protection, and a lower incidence of negative surprises.

In this environment, a focus on quality is key to success. Our approach is focused on finding companies with resilient earnings, a competitive advantage, and strong management teams, and investing in the "large caps of tomorrow".