CPD: The case for Australian mid-caps – why quality is on sale

Market volatility may be putting quality Australian mid-cap businesses on sale for long-term investors.

Share prices move every day. The underlying value of the businesses behind those prices does not move nearly as often, or as much.

That distinction matters more than usual right now. Over the past six months, a run of headline-grabbing developments has driven significant volatility across Australian equities: the acceleration of artificial intelligence (AI) investment, conflict in the Middle East and its impact on energy prices, and federal budget changes to capital gains tax and their flow-on implications for property prices and household spending. Each of these has shaped how investors feel about the near-term economic outlook, and that sentiment has been reflected in share price movements.

However, sentiment is not the same as substance. For most listed businesses, what happens to their share price over a six-month period is a poor guide to what is actually happening inside the business. Management teams control far more of their company’s future earnings trajectory than external headlines suggest. Product development, cost discipline, market expansion and competitive positioning are not decided in response to interest rate speculation or the news cycle.

This is where a useful discipline comes in: when the market is fixated on the present, there is an advantage in asking what a business will look like in three to five years’ time.

That question is particularly relevant for a segment of the Australian market that has been swept up in the recent volatility despite showing little change in underlying operating performance. Australian mid-cap stocks, many of which are genuine category leaders with long runways for growth, have derated sharply over the past six months. For advisers building long-term portfolios, that combination of falling prices and stable fundamentals is worth paying close attention to.

How the ASX is structured

To understand where the opportunity sits, it helps to break the Australian market into three broad segments: large caps, mid-caps and small caps.

Large caps, generally defined as the top 20 companies by market capitalisation, dominate the Australian indices. The S&P/ASX-200 accounts for around 76% of Australia’s total equity market^[1] and within that, the ASX-20 alone represents just over 60% of the ASX-200^[2]. Because most Australian equity portfolios are benchmarked to the ASX-200, that concentration flows straight through to the average investor’s exposure. Financials make up the largest single sector in the ASX-20, at 45.2% of the index, with Materials comprising 24.5%^[3].

Many of these large caps are well established businesses, but that scale often comes with limited room for further share gains. In some cases, it comes with genuine structural risk. The banks are a clear example. For decades, Australia’s big four banks have operated with limited competitive pressure. That has changed; Macquarie Bank has become the first serious new challenger the sector has faced in many years, and the numbers show why incumbents should be paying attention. Macquarie’s home loan book grew by 28% over the year to 31 March 2026, reaching $181.3 billion and taking its share of the Australian mortgage market to around 7.1%^[4]. A few months earlier, Macquarie reported its mortgage book growth has grown by 23%, while none of the big four’s home lending grew at above 7%, well below Macquarie’s pace^[5].

The advantage driving this is largely structural: a lower cost to serve, a fast turnaround for brokers and no legacy branch network to maintain. There is little reason to expect that advantage to disappear, which means the pressure on the big four’s mortgage margins and market share is likely to persist rather than ease.

At the other end of the market, small and micro-cap companies face a different constraint. Many are subscale relative to the dominant players in their category, which typically means weaker unit economics, less pricing power and a harder path to the revenue and earnings growth that drives long-term returns.

Mid-cap businesses sit between these two extremes. It’s important to note that mid-caps are not simply smaller versions of their larger cap counterparts. Many are already the largest player in their specific category – whether that is online property listings (REA), retail jewellery (Lovisa) or furniture (Nick Scali) – yet they retain genuine runway for organic growth and expansion into adjacent markets. That combination, category leadership paired with a long growth runway, is difficult to find further up or down the market capitalisation spectrum.

A passive tailwind has created a mid-cap opportunity

The shift toward passive investing in Australian equities has not happened by accident. Australia’s Your Future, Your Super framework, which came into effect on 1 July 2021, has encouraged super funds to focus more on tracking benchmark risk than on managing capital risk.

The Your Future, Your Super performance test means that underperforming a benchmark can trigger public naming (and shaming), pressure to merge with another fund and member outflows. Some super fund trustees elect to stay close to the index, keep tracking error low and avoid the kind of active stock selection that could see a fund singled out in a bad year. The result has been a steady drift toward passive-like portfolio construction across the superannuation industry.

The effect of this drift toward passive investing shows up in valuations. Index heavyweights such as Commonwealth Bank, NAB, Westpac and Wesfarmers are now trading well above their long-term valuations, despite offering only modest earnings growth. Money flowing passively into the market moves in proportion to index weight, not in proportion to a company’s growth prospects or the quality of its business. The larger a company is, the more capital it receives, regardless of whether that capital is being put to good use.

On the other hand, active managers who typically build more concentrated portfolios around their highest conviction ideas tend to be overweight the faster-growing mid-cap businesses in their universe and underweight some of the largest names in the index. When net flows favour passive vehicles, the mechanical effect is selling pressure on the stocks active managers are overweight and buying pressure on the stocks they are underweight.

This explains why we believe the most compelling opportunities in the Australian market currently sit outside the ASX-20, in the mid-cap segment, where valuations are more reasonable and earnings growth is typically stronger. The move toward passive investment has left a meaningful gap between price and value in Australia’s mid-cap stocks.

Why mid-caps have derated over the past six months

Three separate developments have combined to drive capital away from quality mid-cap businesses over the past six months. None of them relate to a deterioration in the underlying operations of those businesses.

The first is the scale of capital flowing into AI. Equity markets do not have an unlimited pool of capital sitting on the sidelines waiting to be deployed. When a large amount of money moves into one part of the market, it has to come from somewhere else. The recent surge of investment into companies perceived as AI beneficiaries has drawn capital away from other sectors, including some technology businesses seen as at risk of disruption from AI rather than benefiting from it. This rotation – referred to as the ‘SaaSpocalypse’ – has weighed on a number of established, profitable software and technology businesses.

The second is the conflict in the Middle East and its effect on energy prices and inflation expectations. The World Bank has projected that energy prices will surge by 24% this year, reaching their highest level since Russia’s invasion of Ukraine in 2022, as the war sends a shock through global commodity markets^[6]. In Australia, the Reserve Bank expects the effects of higher fuel related costs on consumer prices to peak around the middle of 2026, contributing around 0.4 percentage points to underlying inflation in the year to the March quarter of 2027^[7]. The RBA’s August 2026 forecasts continue to assume that oil prices will decline only gradually and remain above pre-conflict levels for some time, which keeps upward pressure on interest rate expectations. Higher for longer rates are viewed by the market as affecting the discretionary and consumer facing companies that sit outside the ASX-20 more directly than they affect the largest, most defensive names in the index.

The third is the federal budget’s changes to property taxation. The Commonwealth Bank now expects house prices to end up around 3% lower than they otherwise would have been, with dwelling price growth for 2026 revised down to 3% from an earlier forecast of 5%^[8]. That has flow-on implications for consumer confidence and household spending, both of which are considered to matter more for mid-cap discretionary and retail businesses than for the largest, most diversified names in the index.

Capital has moved toward businesses perceived as AI winners at the same time as genuine macro pressure on energy costs, interest rates and household wealth has weighed on sentiment toward consumer facing and growth businesses more broadly. The result is a market where a narrow group of large caps trade at near record valuations despite modest earnings growth, while a wide range of high-quality mid-cap businesses across healthcare, retail, insurance, technology and communications trade near the low end of their historic earnings multiple ranges. We believe this reflects changes in sentiment and where capital has moved in the short term far more than it does a change in future earnings.

AI capex: what should investors expect?

Developments in AI are transformative. Like other major technological shifts through history, there’s little doubt that AI will deliver genuine leaps in knowledge, productivity and capability. A more useful question for investors is not whether AI matters, but who ends up capturing the economic value it creates, and at what cost.

The scale of current spending is considerable. The four largest US hyperscalers – Amazon, Alphabet, Meta and Microsoft – plan to spend roughly $725 billion combined on AI infrastructure in 2026, up around 77% from approximately $410 billion in 2025^[9]. That is one of the largest peacetime capital expenditure cycles in corporate history, concentrated in data centres, chips and networking equipment. It raises question for investors, such as ‘what rate of return is this capital expected to earn’, and ‘how confident can anyone be in that number today’?

History offers a useful guide. Transformative technologies have arrived before, ranging from canals and railways in the 18th and 19th centuries, to electricity, the automobile, the computer, the internet and the smartphone. In most of these cycles, the technology itself proved genuinely revolutionary, yet the majority of capital committed to building it did not generate strong returns for investors. The reason is fairly mechanical. A new technology captures the imagination of a future without limits, which attracts enormous capital. Enormous capital flowing into one space creates intense competition, and intense competition erodes the pricing power and economic returns available to the companies competing for share.

The exceptions to this pattern – Amazon in online retail and cloud, Apple in smartphones, Microsoft in software, Google in search – emerged not because they built the underlying technology first, but because they achieved durable category dominance within it, supported by genuine economies of scale and network effects.

The AI infrastructure race today looks structurally different. It resembles an arms race between several extremely well capitalised players, each reluctant to under-invest for fear of being left behind, rather than a race with a single likely winner. Every major hyperscaler is committing to spend at a similar scale; that dynamic, historically, has tended to compress returns for the companies doing the spending, rather than protect them.

There is a clear parallel with the telecommunications sector. The volume of data flowing through Australian mobile networks has increased many times over across the past two decades, yet most of us pay similar prices for our phone plans as in the early 2000s. Heavy infrastructure investment did not translate into durable pricing power, because every operator had to make the same investment simply to remain competitive.

The early signs in AI point toward a similar dynamic. Competition on the price of AI model access and token costs is already emerging between providers. This is not typically a hallmark of an industry generating outsized long-term returns on invested capital for the infrastructure builders.

None of this means AI investment is unwise for the companies making it. It means the return on that investment is genuinely uncertain, and advisers assessing the businesses their clients are exposed to should be looking for specific, measurable objectives behind AI spending, not simply participation in the theme.

Coming into the reporting season, the more useful signal is whether a company’s AI investment is tied to a defined return on capital and a specific commercial goal, rather than a broad commitment to “AI adoption” with no clear metric attached. Capital discipline does not disappear just because a new technology has arrived. If anything, the scale of spending underway makes that discipline more important, not less.

Genuine moats versus hype

Not every business swept up in the recent technology-related sell-off deserves to be there. It is important to separate businesses where the underlying technology is the moat, from businesses where technology is simply the delivery mechanism for a moat built on something else entirely.

Australia’s online property portals provide a good illustration. There is little meaningful difference in the underlying technology between realestate.com.au and the dozen or so other property listing sites operating in the local market. Yet only one of them is able to consistently monetise those listings at scale. The reason is audience, not technology.

REA Group’s realestate.com.au drew a record average of 12.7 million monthly visitors in FY26, with total monthly visits reaching 146.4 million, around 104.5 million more visits per month than its nearest competitor^[10]. That scale is what allows the platform to deliver the volume of qualified buyer leads that vendors and agents want. Lead generation – not technology – is what a vendor is paying for.

REA’s major competitor Domain reported drawing 7.7 million visitors in June 2026, its strongest month on record, with its audience up 34% year on year^[10]. Domain is a genuine competitor with a well-capitalised media backer that has spent the best part of a decade trying to close that gap – and yet the gap remains wide. This example is a useful reminder of how durable an audience-based moat can be once established. It is also a reasonable test case for what AI means for businesses like this.

The question is not whether AI could theoretically build a better property search tool. It is whether a challenger could realistically pair that tool with a comparable audience of buyers and sellers in a reasonable timeframe. If anything, AI looks more likely to reinforce this kind of moat than erode it. Businesses with large existing revenue bases and large audiences also tend to have the budget and the data to be fast, credible adopters of new technology as it matures. A company the size of REA, with its scale of user data and existing product distribution, is far better positioned to adopt AI improvements quickly than a smaller competitor is to use AI to build an audience from scratch.

This distinction matters when you consider the broader mid-cap sell-off. Some businesses that have derated over the past six months genuinely do have exposure to disruption, where the product is the technology and a better product from a well-funded competitor is a real risk. Others, caught up in the same sentiment-driven rotation, have moats built on scale, distribution, brand or network effects that AI is unlikely to meaningfully disturb. In some cases, AI may well strengthen these moats.

Identifying which is which requires looking past the sector label and understanding what a business actually sells and why customers choose it, which is precisely the kind of company-level analysis that passive, index-based investing is not designed to do.

Over the past six months, a combination of passive flows, AI-driven capital rotation, geopolitical uncertainty and policy change has pushed a meaningful part of the Australian mid-cap sector to valuations that look disconnected from the underlying quality and growth prospects of the businesses involved.

None of this requires a view on which AI companies will win, or when interest rates will next move, to act on. It requires a willingness to look past near-term noise and assess what a business is likely to earn several years from now, and a recognition that quality, category-leading mid-cap businesses, trading well below their historic valuation ranges, can represent a compelling addition to client portfolios.

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Notes:
[1] Market Index at 31 July 2026
[2] Market Index Dashboard, at 31 July 2026
[3] S&P Global at 31 July 2026
[4] MPA Magazine, 8 May 2026
[5] MPA Magazine, 1 December 2025
[6] World Bank, Middle East War to Spark Biggest Energy Price Surge in Four Years, 28 April 2026
[7] Reserve Bank of Australia, Outlook Statement on Monetary Policy, May 2026
[8] Commonwealth Bank, 2026 Budget: Updated Housing Outlook, Commbank Newsroom, May 2026
[9] Value Add VC, AI Spending Tracker 2026: $725B by Big Tech, updated August 2026
[10] Online Marketplaces, REA Group Ends FY26 With Flat Listings and Double Digit Yield Growth, August 2026

The information included in this article is provided for informational purposes only and is general advice only. It does not take into account an investor’s own objectives. The information contained in this article reflects, as of the date of publication, the current opinion of Auscap Asset Management Ltd ABN 11 158 929 143, AFSL 428014 (Auscap) and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Auscap, GSFM Pty Ltd, their related bodies nor associates give any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. Auscap is the responsible entity of the Auscap High Conviction Australian Equities Fund ARSN 615 542 213 and the Auscap Ex-20 Australian Equities Fund ARSN 671 901 821(together, the ‘Funds’). Before deciding whether to acquire, or to continue to hold, units in a Fund, a prospective or existing investor should fully review the information, the disclosures and the disclaimers contained in all relevant Fund documents, including in particular the relevant Fund’s Product Disclosure Statement (PDS) and any update to that document, and consider obtaining investment, legal, tax and accounting advice appropriate to their circumstances. Copies of the PDSs for the Funds are available at www.auscapam.com or by calling Auscap on +61 2 8378 0800. Copies of the Target Market Determinations for the Funds, prepared by Auscap in connection with the Design and Distribution Obligations, are available on request or at www.auscapam.com.