Superior earnings growth to drive small cap stocks: White Paper

(L to R): Richard Ivers & Mike Younger

Superior earnings growth forecasts for small cap stocks relative to larger companies is set to drive a rebound in the smaller end of the market, but active management is key to capitalise on this growth, according to a white paper on Australian small cap companies.

A long-awaited rebound in small cap performance is expected to be driven by improved earnings growth as the post-Covid economy normalises, according to a white paper titled Why Now is the Time to Invest in Listed Australian Small Companies, recently released by Australian-owned boutique, Prime Value Asset Management.

“Historically, Small Cap companies have generated stronger earnings growth than Large Caps which is often a function of their relatively smaller earnings base and market share, with small improvements in market share having a more material impact on earnings growth vs larger companies.

“Equity markets look forwards, however, and consensus estimates once again forecast stronger EPS growth for Small Caps relative to Large Caps over the medium term as the economy normalises post-Covid.”

The white paper says active management has been shown as the best way to capitalise on the opportunities in small cap stocks due to the increased diversification available, the larger universe of stocks, and the relative lack of coverage of these stocks.

Greater diversification allows managers to take a stronger conviction: “…a 10% rise in BHP shares adds a very large 103bps to the Large Cap index return, and so has a large impact on a fund that doesn’t own a position. By contrast, a 10% move in Life360 [the largest constituent in the small cap index] would add just 16bps to the Small Cap index’s performance … placing little pressure on Small Cap investors to own stocks they don’t necessarily have conviction in.”

Smaller companies also provide the opportunity to invest across a wider spectrum of the economy. “A key argument for investing in small caps is the success active Small Cap managers have had in generating consistent alpha.

“This is a function of the relative inefficiencies in the small cap market, such as lower liquidity and less analyst coverage, combined with stronger earnings growth and a more fragmented index composition.”

Managers can also differentiate their performance from the index via portfolio construction: “The dispersion of returns is much wider in small caps than in large cap stocks. While there are high-growth companies that deliver outsized returns, there are also companies that significantly underperform or fail altogether.

“Therefore, avoiding investment mistakes — particularly companies that experience large drawdowns — is a key attribute that can contribute to consistent long-term returns.”