When investor sentiment is extremely bearish, in our experience this has traditionally presented an opportune time to invest.
The S&P/ASX Small Ordinaries index (XSO) is the best understood measure of small-cap performance and is defined by S&P as the performance of companies included in the S&P/ASX 300 but ranked outside of the S&P/ASX 100 (XTO).
Over the past 20 years, the XSO (orange line) has generally underperformed the XTO (blue line), but this underperformance occurred in short bursts, making the annual performance appear worse than it is. This is largely explained by top performing XSO stocks graduating into the XTO, eliminating the opportunity to capture long-term performance. On the other hand, the XSO gains the ‘problem children,’ companies that fell out of the ASX 100 or entered without revenue, which then typically underperform.
The reason for recent small cap underperformance at an index level is simple, inflation. Small companies don’t hold up well during inflationary periods as they do not have the scale, established brands and/or market position to be able to pass through price increases to customers, relative to their large cap counterparts.
Source: FactSet, Clime Investment Management
Therefore, is now the time for small caps? We are strong believers in mean reversion and thus expect small caps will eventually close the gap to large caps. However, with Australian inflation proving to be stubborn, it perhaps may be a little premature for small caps.
Nonetheless, if inflation does continue to decline and bond yields peak, smaller companies typically outperform most when coming out of bear markets, due to higher operating leverage to an economic recovery and GDP growth.
Overlay these growth drivers with an active management approach, and it presents an attractive opportunity to gain portfolio exposure to high quality, profitable companies that are the potential winners of tomorrow.
Source: Seneca Financial Solutions
Disclaimer: Clime Asset Management Pty Limited | AFSL 221146 | ABN 72 098 420 770. The information provided in this post is intended for general use only. The information presented does not take into account the investment objectives, financial situation and advisory needs of any particular person, nor does the information provided constitute investment advice. Under no circumstances should investments be based solely on the information contained therein. Please consider the relevant disclosure document/s before investing in one of our products. Investment in securities and other financial products involves risk. An investment in a financial product may have the potential for capital growth and income but may also carry the risk that the total return on the investment may be less than the amount contributed directly by the investor. Investors risk losing some or all of their capital invested. Past performance of financial products is not a reliable indicator of future performance or returns.