James Barker
Australian small cap industrials are emerging from one of their most volatile years in recent memory, with Ellerston Capital pointing to a combination of AI infrastructure spending and a deepening national productivity problem as reasons the sector is entering what they describe as “its most attractive set-up in years.”
The Ellerston Australian Emerging Leaders Strategy returned 17.1 per cent net over the June quarter, outpacing the S&P/ASX Small Ordinaries Accumulation Index by 13.8 percentage points and the Small Industrials Index by 8.7 percentage points.
James Barker and Jack Briggs, portfolio managers on the Ellerston Australian Emerging Leaders Strategy, say the quarter marked a turning point not just in performance but in market leadership.
“After a year dominated by resources, Small Industrials beat the Small Ordinaries by 5.1 percentage points in the quarter alone,” Barker says. “That rotation matters because it suggests the market is turning back towards fundamentals rather than commodity price momentum.”
Briggs says the dominant theme running through the strategy’s investment universe is the build out of AI infrastructure and electrification. “Order books at electrical services and data centre contractors are now extending into 2028 and 2029,” he says. “That’s a level of forward visibility these businesses have rarely had.”
Underpinning this thesis is a bleaker macro backdrop. Australia has just recorded its first negative decade of productivity growth on record, averaging -0.2 per cent a year across FY21 to FY25, with FY25 alone down 0.7 per cent. Real income per person has barely moved in six years.
“When output per hour worked is flat, a company can only grow revenue by employing more people,” Barker says. “Costs rise in step with sales, margins compress and growth becomes something a business has to buy rather than something it generates.
“Artificial intelligence is the most credible circuit breaker available and that smaller companies are structurally better placed to capture the benefit than large incumbents.”
Adoption remains early with around 12 per cent of Australian businesses, but Briggs says that should be read as opportunity rather than shortcoming.
“The bulk of the productivity gain has yet to be captured. And because smaller companies don’t carry the legacy systems and restructuring drag that slow larger businesses down, the margin gain from AI adoption falls disproportionately to them,” says Briggs.
Barker adds, “This is a rare case where Australia is not simply a price taker in a global technology cycle. We won’t own the platforms, but we do own the two legs that follow; the build out itself and the productivity gain from adoption. Both are investable and both sit in the same part of the market.”
The strategy holds several companies it regards as direct beneficiaries of the build out, including Southern Cross Electrical Engineering and GenusPlus Group, alongside SKS Technologies and Mayfield Group across its wider coverage universe.
On the adoption side, Briggs points to holdings such as Vista Group as examples of software businesses with proprietary data and embedded workflows that the market, in his view, “wrongly assumes generic AI models can replicate.”
“The companies that convert AI adoption into operating leverage will simply grow faster than the economy around them,” Briggs says. “And almost none of them sit in the ASX 20. This is why the opportunity is difficult to access through index exposure.
“Around 68 per cent of the ASX 200 sits in banks, resources, property, supermarkets and utilities. Which we see the industries of the last boom, while information technology makes up roughly 3 per cent of the index, against about a third of the S&P 500. Neither the infrastructure builders nor the AI adopters we hold sit in the top 20 stocks by market capitalisation.”
The return dispersion has been stark. In FY26, the ASX 200 returned 6.1 per cent and the Small Ordinaries 8.1 per cent, against 28.6 per cent for Australian micro and small caps, ahead of the S&P 500 and in line with the Nasdaq. Large caps, meanwhile, are trading on roughly 21 times forward earnings for around 11 per cent growth, a multiple that is expensive relative to what is on offer further down the market.
The strategy targets Australia’s emerging leaders, which make up about 757 listed companies with market capitalisations between $50 million and $2.5 billion. This segment is both the broadest and least-researched part of the ASX, with many companies carrying little or no broker coverage.
They also point to a long run record of active management adding value in the segment.
Over the past 20 years, top-quartile small-cap managers have delivered approximately 4.7 per cent per annum of alpha and were positive at the one, three, five, 10 and 20-year horizons, a record top-quartile large-cap managers have not matched against the ASX 300 at any horizon.
“That reflects a structural inefficiency that’s best captured through deep fundamental research,” Barker says.
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