Are small caps finally back?
Does renewed investor interest point to a structural shift in the underperforming factor?
Historical data shows there are several ‘factors’ or characteristics that drive stock returns. One of these is the size of the company. Small caps have traditionally been associated with a risk premium – a reward for owning more illiquid and volatile stocks with higher uncertainty surrounding their prospects.
All performance factors experience cyclicality, making it difficult to effectively time exposure. Historic US market data shows that small companies outperformed by almost 3% per year on average between 1927 and 2023, but a majority of this outperformance was observed before the 90s.
Source: Wellington Management. 2024.
There is often a disconnect between academic theory and market reality. In recent years, the size factor has struggled to maintain investor conviction, with the current US small cap underperformance cycle spanning almost 15 years. The evidence supporting a small cap return premium has been somewhat ambiguous.
Meanwhile, shifting market dynamics have driven mega cap growth stocks to the forefront. This has skewed long term comparisons and contributed to one of the widest relative valuation gaps since the dot-com bubble. This raises the critical question of whether the current environment presents a compelling buying opportunity, or points to a structural shift in markets favouring sustained large cap dominance.
Morningstar US Large Cap vs US Small Caps over the last decade. Data as of October 2025.
On the domestic front
The Australian market has historically defied expectations of a small cap premium. Over the long term, the ASX 200 has consistently outperformed the ASX Small Ords. That said, there have been select periods where small caps have led the charge.
Source: VanEck. 2025.
However, recently the tide appears to be turning. The Small Ords has rebounded nearly 25% year to date, significantly outpacing a modest 8% gain for the ASX 100.
Morningstar. 2025.
One driver of this resurgence is a shift in the materials sector, which has always held a dominant position in the index (currently 25%). Within this, a surge in investor interest in gold has significantly contributed to the upswing, with the precious metal now comprising 17% of the Small Ords index – well above its historical range of 5-7%.
Nevertheless, small caps rallies have historically been short lived and statistically erratic, with performance highly sensitive to time frames. It is difficult for investors to rationalise whether this is just a momentary rebound or a genuine shift in market dynamics in favour of the size factor.
Rate environment
Small cap companies, often in their infancy are forced to raise capital through debt financing. Consequently, they tend to have capital structures that are more sensitive to short term interest rate movements.
The RBA began cutting rates in February as inflation trended towards target range. As a result, debt servicing costs have become less burdensome, potentially easing financial constraints and enabling opportunities for smaller firms. Eva Cook, Morningstar’s Director of Manager Research, explored this prospect earlier in the year.
Stretched valuations spooking investors?
The ASX 200 currently sits at a trailing price-to-earnings multiple of around 20x, which is well above the level investors have historically been willing to pay. More interestingly, earnings for the largest 20 companies fell again in fiscal 2025, marking the third consecutive year of outright declines.
Australian Ethical. October 2025.
Despite persistent earnings deterioration, investor enthusiasm has remained resilient so far, particularly for the largest players. This has led to a widening disconnect between earnings growth and share price gains at the top end of the market.
Stocks in the Small Ords index currently trade around 5% below our fair value estimate on an equal-weighted basis. By contrast, the ASX 50 sits at a 20% premium.
However, signs of a shift might be emerging. Stretched valuations among large caps appear to coincide with renewed investor interest in smaller companies. But are people misreading the small cap opportunity set?
It’s no secret that the Aussie small cap environment is constrained by structural nuances that aren’t present globally. In particular, an abnormally high number of unprofitable mining companies that drag down the overall quality of the segment in the mining space, indicating a smaller overall opportunity set.
Consider the chart below from asset manager Auscap, which looks at the last decade of performance across ASX size segments. We can see from this that mid caps have consistently delivered stronger earnings growth and superior share price performance. This suggests that there may be a more compelling balance of quality and upside potential to be found in the middle of the size spectrum.
Source: IRESS, Bloomberg, Auscap.
Concerns about stretched valuations at the top appear to be the central case to the recent small cap resurgence. For some, this may signal a compelling opportunity to rotate in, but for others it presents the risk of chasing performance in a segment historically characterised by increased volatility and inferior quality.
Concluding thoughts
History has shown that following periods of heightened market concentration, small caps generally outperform. Given the current market climate, this trend could very well continue, rewarding those who invest in the smaller yet nimble players in the market.
However, the important takeaway here is that the premium has been observed historically, but it is not a guaranteed component of markets. Both large and small caps have undergone long cycles of outperformance. Whilst some still argue in favour of the premium’s existence, it’s not irrational to view it as more conditional, rather than structural. External factors such as macro cycles, sector composition and timing all play a role.
As always, the answer may lie in selectivity. It is difficult to predict the exact timing of a rotation, however momentum-backed rallies into lower quality assets rarely persist over the long term. It might pay to prioritise selective exposure rather than relying on a blanket, size-based thesis.
