The pace at which ASX-listed shares have advanced in recent months suggests a growing void between large and small-cap stocks, and this has become even more evident since August, with trend lines suggesting the emergence of two-speed growth for equities.
Admittedly, it’s no secret that small caps have been leaving their large cap counterparts in the dust for a while now.
After all, the Small Ords Index is up 18.5% over one year while the ASX 200 is up 7.7% over the same time frame.
However, the degree to which the two indices have been diverging has been widening in the last few months.
The ASX 200 has struggled to move 4% higher since early August, while the Small Ords Index is up around 13% on the back of lower interest rates, better economic signals and earnings expectations that exceed those of large caps.
This is a complete reversal of the 23% underperformance experienced by small caps in the three years after Covid, when interest rate rises, inflation and small cap earnings downgrades attracted investors to more liquid large cap stocks.
While the recent recovery staged by small-cap stocks has been well supported by the market, there’s now growing concern that this part of the market is looking a little toppy.
So much so that this concern led Sydney-based fund manager Forager – best known for its high-flying small cap fund – to sell down and exit some of its biggest small cap winners.
So why the U-turn?
It seems the fund manager is now concerned that the blistering rally at the smaller end of the share market has elevated valuations to unsustainable levels.
The Sydney-based firm’s $214.3 million Australian Shares Fund, which topped Mercer’s investment survey earlier this year, has extended its stellar run, returning 42% in the 12 months through September compared to a 21.5% gain for the S&P/ASX Small Ordinaries Accumulation Index.
Admittedly, what’s arguably helping drive up the Small Ords Index is this year’s gold price, with gold stocks comprising around 15% of the index.
Forager’s chief investment officer (CIO) Steve Johnson recently warned investors that if the exuberance for tech and AI continues, Forager’s portfolios may well underperform their respective benchmarks in the near term.
While Johnson acknowledged signs of frothiness across the market, he believes they’re particularly evident in gold, artificial intelligence and defence stocks.
He advised clients on Thursday that there’d been “significant changes” to its portfolio over the past month due to the explosive moves in some of the firm’s holdings.
“We’re in a market where people are paying very, very full prices for the right businesses so it’s important we are completely out of some investments and onto the next opportunity when prices no longer meet the required returns of the portfolio,” Johnson told clients.
Forager’s comments are a reminder to investors that the price at which they enter a stock is critically important to future returns.
So what exactly did Forager offload?
Forager recently exited its long-standing position in sports tech company Catapult Sports (ASX: CAT), which, while technically not a small-cap, sits well outside the ASX200.
Forager bought the stock in June 2021 at $1.90, added to the position in 2023 at around 80 cents and sold it at above $7 last month.
Forager also reduced its position in wealth management software provider Bravura Solutions (ASX: BVS) after its recent earnings upgrade saw the shares reach a five-year high.
With the market littered with “fallen angels” - aka potential value plays – Forager has placed its bets on beaten-up stocks – sitting outside the ASX200 with great care.
In addition to eyeballing Domino’s Pizza (ASX: DMP), the fund manager recently added international education services and language testing provider IDP Education (ASX: IEL), currently the ASX’s fifth most shorted stock.
As CIO, Johnson also tipped up Forager’s holding in payments provider Cuscal (ASX: CCL) - now the fund’s largest holding.
Beware talk of froth?
According to MST senior analyst Hasan Tevfik, sharp gains within a slew of unprofitable ASX-listed businesses over the past six months are clear signs of “frothiness” in equity markets.
Adding to concerns of froth, there are just four periods in the last 25 years when the cohort has rallied so dramatically over a six-month period, including the dotcom bubble, the global financial crisis and the pandemic.
“What you’re seeing right now could be the makings of considerable wealth destruction,” Tevfik noted.
“When these profitless companies generate some returns, it sucks in a lot of momentum investors – many of which are retail investors – at the wrong point, given we’re at the most euphoric point.”
Meanwhile, Bell Potter expects the rally at the smaller end of the share market to broaden beyond the mining sector.
Small industrials have lagged… as investors remained cautious on moving up the risk curve,” said Bell Potter.
“We believe the initial, concentrated phase of this rotation is maturing, and the next leg will be a broadening of outperformance into the industrial cohort.”
Bell Potter’s key picks include AMA Group, Bega Cheese, Cuscal, Centuria Capital, Cedar Woods Properties, Develop Global, Elders, Generational Development Group, Integral Diagnostics, Kinatico, Macmahon Holdings, Nickel Industries, Praemium and Universal Store Holdings.
Bull case for small caps?
Despite the recent rally in the Small Ords Index, Roger Montgomery, founder and Chairman of Montgomery Investment Management, reminds investors that many small-caps are still trading at some of the most attractive relative valuations we’ve seen in years.
Compared to their large-cap counterparts, he says small caps might still be described as exceedingly cheap.
In Australia, small-caps are on the same Price-to-Earnings (P/E) multiple of 20 times forward earnings as their big cap brethren, but they are offering 18% expected earnings growth versus just 4.5% for big caps.
However, despite recent chatter by rival fund managers, Roger Montgomery also reminds investors that small caps remain one of the most under-owned and underappreciated parts of the market.
“This year alone, we’ve seen significant outflows from small-cap equity funds, with investor allocations dropping to historic lows,” says Montgomery.
“Meanwhile, short futures positions on small caps are near record highs, creating the potential for a short squeeze that could push prices higher.”
Renewed investor interest
While there’s no guarantee of continuity, Montgomery says when an asset class falls out of favour, only to show early signs of renewed interest, it can mark the commencement of relative outperformance.
While lower rates arguably ease financing pressures for smaller companies, there’s clearly more to small-cap resurgence than central bank policy.
Small-cap indices are heavily weighted toward traditional cyclical sectors, such as manufacturing, energy, and consumer goods, unlike the tech-heavy large-cap indices.
This means small caps could thrive in a scenario where global growth reaccelerates, providing diversified exposure to any economic recovery.
Another key data point to note, adds Montgomery, is that small-cap earnings revisions have been surging recently, reflecting growing optimism about their future profitability.
“The combination of lower rates, cyclical exposure, and improving earnings momentum forms a strong basis for small-cap outperformance.”
