Investing in the next generation

Why quality small caps offer compelling returns

- Shawn Lee

Investing in high-quality small companies can offer investors significant potential for upside, driven by the capacity of smaller firms to evolve into the large companies of tomorrow.

While challenges remain, green shoots are emerging in various sectors, including the potential for more interest rate cuts in Australia.

In terms of valuations, small ordinaries are trading at fair levels, close to their historical average. Small companies are also trading at similar 2025-26 multiples to the ASX100 index, despite significantly higher expected earnings per share (EPS) growth of approximately 17% compared to the ASX100 at 7%.

While valuations are important, the real excitement for investors lies in the growth potential of small caps. We believe that small companies could be in a position to outperform large caps at this point in the cycle. The current market settings are particularly favourable for Australian small companies to outperform their larger counterparts, and a key factor is the commencement of an interest rate easing cycle by the Reserve Bank of Australia (RBA).

Periods of declining interest rates are often linked to strong outperformance by small-cap stocks. A good example to reference is the RBA's easing cycle in 2015, which exhibited similar settings to what we are observing today, supported by strong labour markets and slowing inflation. The 2015 easing cycle saw the ASX Small Ordinaries index perform strongly, posting a total return of 24.8% over 18 months-well above the ASX100's 3.9% return. This underscores the potential benefits for small caps in a low-interest-rate environment. Lower rates typically boost investor confidence and stimulate cyclical demand, which can be particularly advantageous for growing companies, many of which will also enjoy lower debt service costs.

Reporting season positives