With fund inflows tending to concentrate on the same rogues gallery of large-cap names, being a contrarian investor and not following the money trail - into already crowded trades - may be a productive strategy worth pursuing.
With heavy passive fund inflows having reshaped Australia’s equity market over the last decade, InvestmentMarkets CEO Darren Connolly believes there’s never been a better time for active investors to consider small caps where sentiment is weak, while the fundamentals remain robust.
The combined trading activity of retail investors can move the dial on small cap stocks – albeit it up or down - that bigger investors tend to avoid, and often due to institutional or regulatory issues.
To put the surge in passive capital into context, more than $160 billion is now invested in ASX-listed ETFs - up fivefold in 10 years – a trend that is unlikely to unravel any time soon.
Against that backdrop, Connolly claims there are rich pickings to be found within lower liquidity market segments - that, despite oozing value - appear to have been left behind.
What Connolly is now witnessing on the InvestmentMarkets platform is a notable shift in investor behaviour.
“We’re seeing self-directed investors pair low-cost ETFs for their core exposure with specialist managers for alpha and income,” he says.
“It’s a simple strategy but the specialist satellites are where value now resides.”
Value abounds in small caps
Echoing a similar sentiment, with institutional money reluctant to play in the small cap sandpit, Affluence Funds Management founder and portfolio manager Daryl Wilson agrees that there’s never been a better time for active investors to consider small caps.
The same can also be said for listed investment companies (LICs) that inherently focus on small cap stocks.
Expounding the sentiment of the world’s most successful value investor, Warren Buffett, Wilson reminds investors that typically when the fair valuation gap is this wide, the long-term returns can be exceptional.
Buffett, summed it up nicely when he quipped the immortal line:
“Better to buy a wonderful company at a fair price than a fair company at a wonderful price,” which is exactly what many investors who participate in crowded trades end up doing.
To highlight the disparity between attention-grabbing market darling large-caps and small cap stocks, Wilson is witnessing LICs trade at average discounts of 25-27% to their net asset values (NAV) - the steepest since the pandemic.
“You’re effectively buying a dollar of assets for 75 cents,” Wilson said.
“Even if the NAV discount never closes, the underlying portfolio can still compound at attractive rates. If it does close, investors enjoy an additional benefit.”
Once-in-a-cycle opportunities
The same dynamics are evident across small-cap and micro-cap stocks, where the retreat of super-fund mandates and the surge in benchmark-tracking capital have created some potentially once-in-a-cycle opportunities.
Wilson reminds investors that a valuable tool within a contrarian investor’s arsenal is patience.
It’s true, since the GFC, share markets have traded more on momentum than fundamentals.
However, one of the axioms that made Buffett the world’s most successful investor is simple: When it comes to good companies, the gap between intrinsic value and share price will inevitably close.
“We’re overweight small caps, selective REITs and discounted LICs, and underweight U.S. large-cap tech where we believe valuations have been stretched by AI,” notes Wilson.
The market eventually re-prices excessive optimism and pessimism. Investing early in undervalued assets takes nerve, but we expect it to pay off over a three-year horizon.”
While 2025 may be the year of private credit and chasing yield, both Connolly and Wilson agree that investor behaviour, not just macro conditions, will shape returns in 2026.
“… 2026 could well be the year of rediscovering value,” Connolly said.
“Investors who look beyond the noise might well find attractive opportunities hiding in plain sight.”
During the FY24-25, Australian small companies experienced both sharp pullbacks and strong rallies, resulting in double-digit returns to investors on the back of shifts in government policy, changing economic conditions and ongoing geopolitical events.
Mind the gap
The underperformance of small caps first emerged when interest rates started going up aggressively as central banks around the world attempted to rein in rampant inflation.
However, despite some unravelling in interest rates, the significant performance gap in small caps - both in Australia and globally - relative to large caps remains high at around 33%.
According to Dominic Rose, portfolio manager at the Montgomery Small Companies fund, this gap is an interesting viewpoint from which investors can assess opportunities within the small cap space.
Rose also believes the more stable macro backdrop is highly supportive of small caps moving forward.
“Getting back to a low growth world, investors can get back to stock picking and given that there’s significantly more earnings growth in small caps - relative to large caps at the moment - we think there’s a lot of opportunity for small caps to do quite well,” said Rose.
Given that small caps are deemed by the market to be more macro or economically sensitive, Rose expects them to benefit from additional rate cuts by the Reserve Bank.
The Small Ords Accumulation Index is now delivering three-year EPS compound growth of 26% annually, compared with the ASX100 Index’s 4% annual earnings growth.
On the valuations front, the Small Ords has a two-year price to earnings multiple of just 16x, relative to the ASX100, which has a price to earnings multiple of 18x.
“So there’s a strong argument for small caps based on growth and valuation,” said Rose.
