Aussie equities: Opportunities in ASX small caps as rate cuts loom

Active small-cap managers are delivering strong returns despite index underperformance. Pendal portfolio managers LEWIS EDGLEY and PATRICK TEODOROWSKI explain why

• Small caps could return to favour as conditions evolve
• Quality earnings the key
• Find out about the Pendal Smaller Companies Fund

IS IT time to invest in ASX-listed small caps?

It’s a question investors are asking ahead of potential global rate cuts which could bring a long period of small-cap underperformance to an end.

But while it’s tempting to focus on timing, the unique nature of small-cap indices means a careful stock-selection approach can outperform regardless of broader market conditions, argue Pendal’s Lewis Edgley and Patrick Teodorowski.

“As a whole, small caps have been a significant underperformer relative to large caps over the last two years and people are asking us ‘is now the right time to be investing?’ says Edgley.

“My answer is the underperformance problem isn’t just a two-year problem – it’s a two-decade problem.

“The Small Ordinaries index has generated a 5.5 per cent compound annual return for 20 years, versus the ASX 100’s 8.8 per cent.

“But the median small-cap manager has returned 9.7 per cent over the same time.

“That tells you what an active small-cap manager can do when they’re able to sift through the maze of good and bad investment opportunities that the Small Ordinaries provides.”

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.

Unique opportunities and challenges

The Small Ordinaries index – which includes companies included in the ASX 300, but not in the ASX 100 — presents unique challenges for investors due to a wide array of industries and companies.

The index can often include faddish companies that enter the index with high expectations before underperforming as their popularity wanes.

It can include single-play resources companies that rally and fade as commodity prices fluctuate.

“We get themes that run and components of the index that get significantly exposed to that theme. Then as the theme runs its course, performance ends.

“But despite the fact that the benchmark has only delivered a 5.5 per cent a year over 20 years, by being dynamic and identifying the better-quality companies, we’ve been able to navigate that and find money-making ideas.”

Since inception in 1992, the Pendal Smaller Companies Fund has generated an after-fees return of 11.95 per cent. You can view the fund’s performance over other time frames here.

Rate cuts could spur performance

Small caps are historically correlated to changes in interest rates, argues Edgley.

“We have a blueprint for this in many cycles, whether it’s the GFC or Covid – declining interest rates are usually a tailwind for small caps relative to large caps.

“Over the last two or three years, small caps have essentially been driving with the handbrake on.

“We don’t know when rates are going to start coming off. But when they do, small caps should start to get a tailwind.”

What does that mean for timing?

“We think it actually doesn’t matter – our history shows there are ways of finding money-making opportunities regardless of what rates are doing.

Find out about

Pendal Smaller
Companies Fund

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“Small caps have historically traded at about an 8 or 9 per cent premium relative to large caps for the past 10 years – and they are at about that same premium today.

“Most people want to buy small caps when they are cheap. You could argue that as it stands, small caps aren’t cheap.

“In any case, our view is that buying the cheapest small caps generally isn’t the best way to make money.”

Earnings drive performance

“We don’t focus on the price-to-earnings ratio as the starting point – we focus on earnings and earnings quality,” says Teodorowski.

“Through the last two years of a challenging macro and market environment for small caps, we’ve been able to identify two groups of businesses: structural growth businesses that we were able to put more capital in at a better valuation; and businesses with more defensive earnings than the market thought, which have rebounded significantly.”

Edgley adds: “The reason we feel confident that we can continue to do this is due to the composition of our performance over time.

“The value we’ve created hasn’t just come through a very small number of big bets going well, it’s come through a broad combination of lots of things going well.

“That’s much easier to replicate going forward.

“If you can do lots of small things well over time, that can compound to a really great outcome.”