Unearthing hidden gems and securing small cap outperformance

An extreme underperformance of small companies compared to large companies suggests small companies could be in a position to play catch-up to large caps and outperform over time.

- Callum Burns

However, careful selection is paramount to back winning companies, which are likely to be those with strong business franchises with an ability to fend off competition and enjoy strong earnings growth.

While the ASX Small Ordinaries Index offers investment opportunities across a broad range of industries, ICE Investors believe individual stock opportunities are even better than the index opportunity. An ideal investing approach should be centred on finding the hidden gems in the small cap sector, that is, companies with an economic moat that will help to generate strong earnings over time. Businesses that boast difficult-to-replicate assets, enjoy a sustainable competitive advantage, hold an entrenched market position, and enjoy pricing power can deliver enhanced returns for investors an ideal combination for a winning investment.

Indeed, right now, we see a positive outlook for small caps due to the extreme underperformance of small companies in recent years compared to large caps. In many instances small cap companies are less impacted by potential tariffs than large caps.

However, the potential for small caps to outperform traditional blue-chip shares, such as the big banks and big miners, depends on some important factors. To outperform, companies need a strong business franchise; this is characterised by several key features, including difficult to replicate assets, such as licenses and brands, a good quality management team, an entrenched customer base, a sustainable competitive advantage and barriers to entry for new competitors, which helps to establish a company’s economic moat and therefore pricing power.