Small cap companies are tipped to outpace their large cap counterparts because they are more exposed to the cyclical upswing and investors are prepared to take on more risk as the recovery firms.

The S&P/ASX Small Ordinaries Index has gained 3.5 per cent over the year to date (19 March 2021), while the S&P/ASX 200 has increased just 1.8 per cent.  Both large and small caps have outperformed the overall share market, with the S&P/ASX 20 up 3.0 per cent.

“Small caps typically outperform in an economic recovery given the smaller end of the market is generally more sensitive to the economic cycle, being less insulated in tough times but offering a lot of operating leverage when things improve,” says Matt Griffin, co-portfolio manager small caps with AMP Capital.

“The earnings outlook for small caps is very strong for the year ahead. Earnings expectations for small cap companies have risen 20 per cent over the past few months and are now back to near pre-COVID levels, and with a favourable economic backdrop, small cap earnings should rebound and grow faster than large caps, which is likely to lead to outperformance,” Griffin says. 

Growing economy

Australia’s economy has emerged convincingly from recession. The economy grew 3.1 per cent in the December quarter and 3.4 per cent in the September quarter. This was the first time in the over 60-year history of the ABS’s measurement of gross domestic product (GDP) that it has grown by more than 3 per cent in two consecutive quarters. Year-on-year, the economy shrank 1.1 per cent in the December quarter, reflecting the COVID-19 impact.

“The consumer is currently flush with cash given government stimulus measures and a very high savings rate last year. We see continued strength in spending on housing, cars, and household items, combined with the potential for pent-up demand for travel to flow through once borders open,” Griffith says.

“While small caps do tend to have more of a growth bias and may underperform large caps for periods where value investing is favoured, there are plenty of value stocks in the small-cap space.”

According to Shane Langham, a senior private wealth adviser with Sequoia Wealth Management and author of the Charting Wisdom share market report, small caps have easily outperformed over the past 12 months.  

“If we look a little closer at the last 12 months, we can see that not only have the small caps outperformed the big caps, they have done so by a very healthy margin of 67 per cent currently. What this implies to me is that with the rollout of stimulus programs in Australia and around the world, investors have moved up the risk curve,” says Langham.

“With interest rates at historical lows, globally people have no choice but to do so in order to get a return on their money. Since there looks like there will be no or little change with rates over the next two to three years according to the major central banks around the world, I would expect to see this outperformance of small caps over big caps continue,” he says.

Trevor Gurwich, portfolio manager at American Century Investment, says the potential for greater merger and acquisitions activity in 2021 will also support small caps as they tend to be the greatest beneficiaries of M&A activity.

“Small-cap valuations still look attractive relative to large caps, globally. We believe the combination of more attractive valuations and faster expected earnings growth for small caps relative to large caps bodes well for returns,” Gurwich says.

Wind in the mid-cap sails

But mid-cap stocks will perform best, according to Sequoia Wealth Management’s Langham. He says the star performer over the past year has been the S&P/MidCap 50 Index, having outperformed the overall share market and small caps. That Index is up 69 per cent of the year to 19 March. The longer the time frame the greater the outperformance, says Langham.

“If you're looking for growth, then you really need to be looking at the smaller to mid-cap end of the market as this is where the outperformance has been for at least the last five years and I don't see that changing in the current economic environment,” he says.

According to a research paper by James Abela, portfolio manager of Fidelity's Future Leaders strategies, and co-portfolio manager Maroun Younes, “the rotation towards value, small cap, cyclicals and non-US stocks seems to be gathering some momentum. These are reversals that have long been needed by the market for the sake of its long-term health,” they say.

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See also Morningstar Guide to International Investing.