Home / Small caps / Stars aligning for ‘unloved’ small caps as divergence signals strong returns

The Australian small-cap sector is currently trading at a whopping 30 per cent discount, according to new research from Datt Capital, with history suggesting strong returns are likely to follow as active managers continue to show their skill in this buzzing space.

If it seems like Australian small caps are getting outsized attention these days, it’s for good reason. According to Datt Capital, this sector’s “somewhat unloved” status has made it attractively cheap, with such deep divergence historically heralding a period of strong returns.

“That the Australian small-cap sector has been somewhat unloved in recent times can be seen through the prism of current valuation,” says Emanuel Datt, the fund manager’s chief investment officer. “On a five-year rolling timeframe, the ASX small-cap index is trading at a substantial divergence from the broader All Ords market index.”

That divergence, according to recent research by Datt’s firm, amounts to a 30 per cent discount for Australian small caps in the current market environment.

Moreover, Datt points out that in comparison with the 20 per cent premium the small-cap index has typically traded at, this sector is currently experiencing a 50 per cent divergence from the historical norm.

“Whenever this has occurred, it has portended periods of strong returns for small-cap investors,” he says. “A lot of this is driven by what many call ‘the invisible hand’, namely, the effect of the free market and its participants, which act as drivers for the index to mean-revert over the medium term.”

Future Fund on board

In light of this and the uncertainties overshadowing global markets, Datt says, it “should not shock” that Australia’s $206 billion Future Fund recently drew attention to the “persistent alpha opportunity” in Australian small caps.

The sovereign wealth fund announced in September that it would mandate an external investment manager and focus for the first time on the small-cap space. The move marked the fund’s return to active management strategies after its 2017 transition to passive and smart-beta equity investing.

At the time, the Future Fund noted that Australian small-company stocks have a lower level of analyst coverage relative to other domestic equities segments. That means higher dispersion and greater forecasting error – “code for alpha opportunity”, according to Datt.

He sees in small caps “an investable universe of more than 1,500 separate listed companies identified with a market cap of above $20 million and outside the ASX 100 index”, including many that are not dependent on macroeconomic factors and “provide the potential for strong idiosyncratic returns”.

“This allows investors to capture a pure form of sector exposure, as small companies are typically more focussed and concentrated in their operations,” he says.

Datt notes that smaller companies have begun belt-tightening in the current soft economic environment and in the face of rising capital costs.

“The size of these companies means they fall under the radar of many or most institutions,” he says. “There is much less investor interest generally in this sector and therefore greater opportunity of strong returns for those investors who believe in conducting intensive research.”

In fact, primary research is critical to finding hidden small-cap gems, Datt says, as investors must understand the technical aspects of a company’s performance as well as how economic factors affect its fundamentals. He urges investors to “look for invisible data that lies outside the standard stock screening software, using primary data”.

Active managers outperform

The positive assessment of the state of small caps and the opportunity for active management appears borne out by a recent Morningstar report highlighting the outperformance of active funds in the Australia small-cap space.

Morningstar’s inaugural Active/Passive Barometer measures the performance of active funds against a composite of passive fund performance in nine categories over the three-, five- and 10-year periods through June 30, 2023.

“The study reinforces some of the long-held Morningstar views such as the superiority of active funds in categories like Australia mid/small blend and Australia large-value equities, whereas low-cost passive funds remain dominant in efficient markets when representative indexes are available,” according to the report.

This track record supports the limelight moment Australian small caps are currently experiencing, with abundant opportunities in a sector poised to deserve some more love, Datt says.

“The move by the Future Fund into this space does not surprise. They, like us, are acutely aware that every large-cap company commenced life as a small cap.”