Australian small-cap investors are licking their wounds after the Iran war, rising bond yields, and persistent inflation brutalised the market. But they are confident the bottom is approaching and say the time to buy is now.
The S&P/ASX Small Ordinaries Index has fallen nearly 18 per cent in the past 12 months, marking its most dramatic annual plunge since the COVID-19 pandemic. By comparison, the ASX 200 has dropped about 3 per cent.
One of the biggest factors in the small-cap winter has been this year’s move higher in bond yields, driven by resurgent inflation from rocketing oil prices, the unprecedented artificial intelligence boom, and stubborn inflation that has forced central banks from Australia to the United States to lift rates.
“Life is more generally more difficult for small caps in a rising bond yield environment,” said Pengana emerging companies fund portfolio manager Steve Black. “It’s a sign of risk aversion in the market and typically investors gravitate to larger caps with more liquidity and perceived safety.”
Black’s fund is one of many in the industry that have endured a rough year, having fallen 21.6 per cent in the year to September. However, it has still outperformed its benchmark, the ASX Small Ordinaries Index, by 5.6 percentage points since inception in November 2004.
He says another factor weighing on small caps has been the Reserve Bank of Australia’s aggressive rate-rise cycle, which disproportionately affects smaller companies as they are more reliant on debt. The RBA has lifted the cash rate four times this year to 4.6 per cent, the highest level since 2011.
Black is confident that several recent losers in his portfolio – including financial services business Generation Development, down about 60 per cent in the last year, and wealth platform Netwealth, which has dropped 50 per cent – are primed to rebound.
“Their share prices have been hampered as investors looked for funding to go into the more sexy AI industry,” said Black. “But they ultimately have exceptional runways to growth for the next three years.”
He also likes FDC Consolidated, a construction and fitout company that has risen nearly 10 per cent since its sharemarket debut in July.
Other investors have been whacked even harder, with Hyperion’s small growth companies fund, the Microequities deep value fund, the Lakehouse small companies fund, and Selector small companies fund all down more than 30 per cent in the past 12 months, according to Fund Monitors.
Regal’s Australian small companies fund, run by Jackson Aldridge, has dropped 16.3 per cent in the year to September, although it has still beaten its benchmark by 12.1 percentage points a year since inception in 2015.
Aldridge also linked the sector’s punishing year to rising interest rates. But he said that given the Small Ordinaries Index was now trading at a price-to-earnings multiple of about 15.5, compared with the ASX100’s roughly 17, which marked a relative 15-year low, small caps appeared cheap.
Aldridge is bullish on the ASX’s defence sector amid surging global military spending, including Codan, which supplies a radio frequency component the size of a mobile phone to drone manufacturers in the United States and Europe, defence technology player Elsight, and shipbuilder Austal. He also likes gold miners including Genesis Minerals, Ora Banda, and Forrestania.
Seneca’s Australian small companies fund is one of only a handful to stay in the green, having returned 5 per cent in the year to October. Its largest holdings include fund managers HMC Capital and Regal Partners, laboratory testing consumables and equipment provider XRF Scientific.
“We see value in almost every sector of the market right now,” said Seneca portfolio manager Luke Laretive. “From fund managers to real investment trusts and retailers. We can’t really remember a time when we have this many holdings that we expect to generate a more than 100 per cent return.”