Why it might be the perfect time to invest in small-cap companies

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History doesn’t repeat, but it does rhyme – and if this adage holds true, small caps are likely to present strong opportunities for patient investors over the coming years.

In calendar year 2022 the benchmark S&P/ASX Small Ordinaries index delivered a return of -20.7 per cent, which was one of the largest drawdowns in the benchmark’s history. The positive coming out of such a soft year is that, historically speaking, the years following a material small-cap drawdown often prove to be a great opportunity to invest.

Focusing on small-cap companies, rather than big blue-chips, can give investors better returns.Credit: Simon Letch

Our analysis shows that if you were to invest immediately following a drawdown year of -10 per cent or worse, the average compounded return for the three years following would deliver 35.2 per cent.

The caveat is that you need to remain in the market to enjoy the recovery. So, as investors ponder when is the right time to re-enter small caps, we suggest focusing on time in the market as opposed to timing the market.

Despite our optimism for small caps, we recognise they will face economic headwinds as do many businesses in a period of slower economic growth. Businesses are leaning into a difficult operating environment – rising interest rates, inflation, stalling consumer spending, and declining house prices – all of which have flow-on effects for the broader economy. A tricky time to invest, indeed.

The volatility inherent in small caps also creates opportunities, particularly for active investors with portfolios constructed on strong fundamentals – businesses identified as having strong competitive advantages, defendable margins and forecastable earnings. Interestingly, these are no different to the criteria that are often used to define the best businesses in the large-cap universe of the S&P/ASX100.

Add to this the drawdown of calendar year 2022 resulted in a relatively broad-brush approach taken to many small caps, with the result in many instances meaning the baby was thrown out with the bathwater.

As is often the case with small caps, even the share prices of superior businesses suffered from the investor retreat to the “safe havens” of large caps and fixed-income securities, including term deposits. We believe herein lies the opportunity.

Have we hit the bottom?

The conundrum small-cap investors now face is: how do they balance the risk of further earnings downgrades and share price declines with the compelling valuations that have emerged from the sell-off?

Sharemarkets move with forward-earning expectations, but also tend to overreact to both negative and positive news. This is particularly so for the small-caps market, which is often less efficient and more focused on the short term, hence its greater volatility.

There will undoubtedly be more earnings downgrades as certain sectors continue to feel the brunt of higher interest rates and inflation, but equity markets are forward-looking and the next set of downgrades may indicate we have reached the bottom of the earnings trough for this cycle.

The key is to look through the market noise to identify the best-quality businesses and opportunities. A starting point for us as minority shareholders is that we have financial alignment and confidence in the board and management of the companies we look to invest in.

We spend considerable time engaging with business leadership and understanding the company’s products, services and operating markets. We must have confidence in the leadership’s ability to successfully execute their strategy, and understand how this can benefit all shareholders.

Opportunities, but be patient

We currently see some outstanding growth opportunities across the small-cap marketplace. These include companies operating in a range of industries and sectors as diverse as travel and tourism, transport and infrastructure, and technology. However, we also believe there are some small caps for which investors are paying excessively high multiples, of which we will steer clear.

With that in mind, here are some stocks we look at as compelling opportunities over the medium term:

1. Kelsian Group operates a portfolio of tourism and public-transport assets across Australia and various global markets. We are attracted to the defensive growth characteristics of the business, which is a product of both the contracted nature of the public-transport division and management’s ability to drive growth through winning and retaining contracts.

Looking forward, we believe the outsourcing of government contracts to the private sector presents an attractive structural-growth story, and the recent acquisition in North America provides an exciting opportunity to accelerate expansion into a large, under-penetrated market.

2. HUB24 is Australia’s second-largest independent platform provider with $62 billion in Funds Under Administration (FUA) in a ~$1 trillion industry. The company’s industry-leading net inflows are driven by market-leading technology functionality, which presents a significant runway to materially increase its FUA, expand its economic footprint, and generate material EPS growth over the next five years.

As in any sector of the market, the key to achieving optimal investment returns is proper due diligence – research, comprehensive engagement with business leadership, and a deep understanding of the sectors in which they operate.

For patient, strategic investors there is strong opportunity in quality small caps as we look to rebound out of a tough year in 2022.

Liam Donohue is a principal and portfolio manager at Lennox Capital Partners.

• Advice given in this article is general in nature and is not intended to influence readers’ decisions about investing or financial products. They should always seek their own professional advice that takes into account their own personal circumstances before making any financial decisions.

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