Aussie equities: Why conditions are favouring smaller companies again

Aussie small caps are once again outperforming large caps. Pendal portfolio managers LEWIS EDGLEY and PATRICK TEODOROWSKI explain why

• ASX small caps are back in favour with investors
• Earnings holding up better than expected
• Find out about Pendal Smaller Companies Fund

AUSSIE small caps are once again outperforming their large-cap counterparts after a period of underperformance in recent years.

Conditions have turned in favour of ASX-listed small caps in recent months and Pendal portfolio managers Lewis Edgley and Patrick Teodorowski believe that trend will continue.

Edgley and Teodorowski co-manage Pendal Smaller Companies Fund, which invests in companies outside the top 100 listed on the Australian and New Zealand stock markets.

Together the pair have 25 years of experience with Pendal Smaller Companies Fund. (Teodorowski has been with the fund for 14 years and Edgley for 11.)

In this article, the pair explain why small caps underperformed, how conditions have changed and what they’re doing to take advantage.

Why small caps under-performed in recent years

Small caps underperformed large caps in 2022 and 2023 as higher rates and recession fears pushed investors towards larger, more established companies.

When markets first anticipated a rapid post-pandemic rate-rise cycle, that precipitated a significant underperformance of small caps, relative to large caps, says Edgley.

Many companies in the large cap index — such as banks and insurers — were natural beneficiaries of a rising interest rate environment.

“In the small-cap universe, the composition was quite different,” Edgely says. “For example, we’ve got a large proportion of real estate trusts where rising rates hurt their valuations.”

“We’ve also got a high degree of economically-sensitive businesses.

“When you have a fear of recession these businesses are typically sold off. That happens in advance of any earnings impact as sentiment weighs on those types of businesses.”

At the start of that period small caps had a significant premium compared to large caps, which also exacerbated their relative underperformance.

How conditions changed in favour of smalls

This year, as recession fears dissipated and inflation began moderating, investors regained interest in smaller companies.

“We’ve had the US Fed on hold and the Australian RBA on hold, and in that environment the market starts to anticipate things improving and a shift to the other side of the interest rate cycle, which is rate cuts,” Teodorowski says.

“We’ve also subsequently seen earnings hold up significantly better than investors feared.

“We’ve seen a re-rating of companies that were most likely to feel the pain of higher interest rates.

“More fundamentally, over the past two earnings seasons we’ve seen greater resilience out of the more cyclical companies within our index.

“They’ve been able to manage their earnings far better than the market expected.”

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Materially lower valuations and a low Australian dollar has prompted more merger and acquisition activity in the last six months, says Teodorowski.

An expected flurry of “new and bigger Initial Public Offerings” should also see increased demand and investment opportunities.

What sets Pendal’s small caps team apart

“We believe a few things set us apart as quality small-cap investors,” says Edgley.

“The key driver is the breadth and depth of the team.

“We’re a team of five. That would be one of the largest, dedicated small cap teams in the market.

“We’re also supported by the broader Pendal Aussie equities team. So in total there’s 19 of us.“

A larger team allows Pendal to cover a lot of ground — which is very important in small-cap investing, Edgley says.

“The small-cap universe is very diverse by sector. There are always new moving parts. The refresh within the universe is significant.

“With sectoral responsibility across all areas we’re able to make active decisions in certain sectors, and we think we’re able to make the best investment decisions.”

Active management important

“The process has always revolved around going out and wearing out boot leather,” says Teodorowki.

“We do a lot of direct meetings with the management of companies. We meet with other industry participants, whether customers or competitors.

“That’s always been a big part of the process in coming up with a view on a business.

“Another big part of our process is peer review. Lewis and I are not only portfolio managers, we’re analysts.

“When any idea gets brought to the team, we all sit around as a group and debate the merits of that investment as a team.

“The five people in the team are very experienced. This brings a different lens into analysing the business. It normally raises additional questions and drives deeper research into the investment idea.”

Says Edgley: “It’s very much style-agnostic, bottom-up idea generation. “We take a pragmatic view of the opportunities in front of us and converting those opportunities.