Australian smaller companies have delivered their best earnings results in more than 25 years but doubts have been raised about their valuations, according to Goldman Sachs.
‘Small-cap’ stocks increased earnings by 8.5% year-on-year in the period ending 30 June, the broker wrote in a portfolio strategy research document.
“The results mark a potential turning point for the sector, which has struggled in the post-COVID era amid rising interest rates, wage pressures, and weak domestic demand,” Co-head of Australian Research and Head of Portfolio Strategy & Quant Research Matthew Ross and Associate Tony Wu wrote.
These stocks have underperformed large caps by 27% with a -10% return compared to +17% for larger peers since late 2021, when markets began pricing in higher inflation and interest rates.
This was a result of smaller companies relying on short-term floating-rate debt and having a greater exposure to labour-intensive business models, which suffered disproportionately in the monetary policy tightening cycle.
They derive a much higher share of revenue from the cyclical and rate-sensitive sectors like retail, housing and domestic services, which had underperformed global benchmarks until recently, but recent results suggested a reversal may be underway.
“Yet, the rally has raised questions around valuation,” they wrote.
At the time of the document the Small Industrials index was trading at 23.5 times forward 12-month earnings estimates, which, at a discount of 6% to large caps (25x), was historically near the top end of the range.
But analysts cautioned that earnings remained well below potential, with forecasts about roughly 5% below pre-COVID levels, while large-cap earnings are projected to be 20% higher than their 2019 levels.
“For investors, the road ahead will hinge on whether the earnings recovery can catch up with elevated valuations—and how the domestic economy responds to further monetary easing,” Ross and Wu wrote.
The Goldman Sachs perspective has been echoed by other analysts and investors who remain cautious with optimism about attractive valuations and improving economic conditions tempered by worries about valuations and the earnings outlook
