Could Small Caps Could Benefit From a Market Bounce?

Valuations for the Australian small cap sector have recently fallen close to decade lows and could provide opportunities for investors to buy-in. We take a closer look at the market and some of the factors to consider.

A global comparison

E&P Chief Investment Officer, Tim Rocks says the sell-off has impacted Australian small caps more than their global counterparts ― but there are a number of reasons why this has occurred which offers some valuable context.

He says: “In the US, market indices and valuations have been largely driven by movements with the FAANG stocks, so mid caps will be less vulnerable to a valuation correction ― whilst in the UK, mid caps provide a greater exposure to the domestic recovery and currency upside.

This is why the small cap part of the Australian market stands out. Currently, it presents opportunities where investors can be rewarded if they look through short-term concerns and focus on the potential for stronger long-term returns.” he explains.

The upside of the downside

Small caps have been particularly affected by this selloff, far more than in previous episodes and Rocks believes the sector is well positioned to outperform once markets turn for several reasons.

• The ‘small ords’ – the small cap component of the Australian stock market – has fallen by double the overall market i.e. -24 per cent versus almost -12 per cent since December, whereas in previous market selloffs, on average the small ords fell by less than the market.
• The “downside capture” this time is 204 per cent versus the historical average of 83 per cent, which now seems to be reflected in valuations.*
• The price to earnings ratio for the small industrials has fallen to 12 times, excluding resources, and has only been lower in the depths of the global financial crisis and the 1990 recession. Small companies appear to be priced for a severe recession ― however, the gap between large cap and small cap valuations is close to record highs.
• Small caps have also historically had high betas to a recovery. They have had more “upside capture” in the first six months of a recovery i.e. 142 per cent, than “downside capture” in the sell off. Given the lower starting point, this could be even larger this time around.*

Assessing investment opportunities

Rocks says a key consideration when assessing investment opportunities is that the small cap sector has historically outperformed during market recoveries and businesses with strong underlying fundamentals could deliver healthy returns.

He says: “This is where it pays to take a deep dive into what’s driving a business ― such as its competitive advantage, the size of the addressable market, funding structures and the quality of its management team.”

“However, with around 2000 Australian small caps listed on the ASX, undertaking this level of research across the sector is a substantial task for most investors ― and one which can be effectively handled by a specialist manager in the space.” he adds.

Looking ahead

Rocks says based on current market conditions, increasing exposure to small caps now seems to be a good way to start positioning for a market bounce.

He says: “The upcoming reporting season will be an important event and investors are concerned that there will be widespread downgrades. If it is not as bad as feared, then this rally could start soon. Investors should stay close to their advisers.”

You can also read more about what’s separating the haves from the have-nots in small caps.