Callum Burns
While small capitalisation stocks have significantly underperformed large companies since the start of 2022, many quality small cap companies possess superior earnings profiles to large companies and have been indiscriminately sold down.
That’s the conclusion reached in The Small Cap Dislocation, a new research paper which assesses the performance of the Australian small caps sector.
The research separates companies of the ASX/ S&P Small Industrials into two halves – one half consisting of higher-quality companies with superior earnings growth, profit margins and debt profiles, and the other half consisting of lower quality companies.
It found that while low-quality small cap companies deserve to have underperformed the S&P/ ASX 100 Industrials Index, the higher-quality half of small caps have been oversold versus large caps.
Earnings growth, debt levels and profit margins of these companies compared to the S&P/ ASX 100 Industrials are typically more favourable and, therefore, the large underperformance of this quality group of small companies since 2022 versus large caps stocks is unjustified.
The ASX/ S&P Small Industrials Index was chosen as the control group to focus on the underlying drivers of small companies. The group was split into five quality categories, including ‘best franchises’, ‘solid franchises’, ‘typical company’, ‘below average company’ and ‘challenged and/ or loss-making’. The consensus forecast earnings growth for the year ending June 2024 was then obtained for each company across each category, and the median was calculated for each Small Industrials quality category. The same process was repeated for the Top 100 Industrials.
The earnings growth in the higher quality half of the ASX/ S&P Small Industrials is superior to that of the same quality categories in the Top 100 and superior to that of lower quality companies, whether in the Top 100 or Small Industrials. This suggests for the higher quality categories in the Small Industrials Index, the underperformance of this group since the start of 2022 is not justified.
The median quality small cap franchise in the higher quality half has better earnings growth, slightly lower debt levels and slightly higher profit margins than Top 100 companies. In contrast, earnings growth in the lower quality half of the Small Industrials is materially inferior to that of the same quality categories in the Top 100.In aggregate, the three lower quality categories have uninspiring earnings growth and trade at a discount
The findings of the research illustrate that the more challenging investment environment since the start of 2022 has unsettled investors. As a result, they have responded by buying into the perceived safety of large cap stocks and overlooked indiscriminately sold down small caps.
The sell-off in quality small companies has opened up attractive buying opportunities for shrewd investors prepared to do the work and potentially unearth quality companies with robust earnings growth, good profit margins and low debt levels – something investors in all segments of the market should be aiming for.
By Callum Burns, managing director and Roger Walling and Mason Willoughby-Thomas, portfolio managers
