Maple-Brown Abbott reckons 2024 could be the best year for small caps since the GFCOphir Asset Management says small cap valuations are the cheapest they’ve been in 15 or 20 yearsRed Leaf Securities says ‘2024 will be the year of the small cap recovery’ after two tough years Despite somewhat of a sluggish start to 2024, fund managers and analysts are optimistic for equity markets, particularly the smaller end of townPortfolio managers at Maple-Brown Abbott reckon with inflation looking like peaking and an end to the rate hiking cycle of central banks in sight, 2024 has a shot at being the best year for small caps since the Global Financial Crisis.“We believe the Australian small caps market is at an inflection point given the more favourable macro-economic backdrop and expected earnings trajectory,” says Australian small companies co-portfolio manager Phillip Hudak.“With a lot of negative sentiment priced in to Australian small companies, and signs that financial conditions are easing, inflation is moderating and interest rate rates have peaked, we believe we are seeing one of the most favourable environments for the Australian small caps market to outperform in 2024 since the global financial crisis.”Australian small companies co-portfolio manager Matt Griffin agrees and points to key themes that may emerge in small caps in 2024.While our bottom-up investment process is focused on idiosyncratic exposures, key themes we may see in 2024 include the under-estimation of wage inflation, a ramp-up in corporate activity, strengthening fundamentals in the uranium sector and potential re-emergence of the gold sector,” Griffin says.Outsized underperformance of small caps set to endAccording to S&P Dow Jones Indices the S&P ASX 200 benchmark finished 2023 with a gain of 12%, closing just 0.3% away from a record high.The S&P ASX Small Ordinaries finished 2023 up 7.82%, the S&P ASX Mid Cap 50 rose 7.76%, while the S&P ASX Emerging Companies index was just short of ending 2023 in positive territory, finishing down 0.36%.Ophir Asset Management specialises in small and mid cap equities investing both in Australia and globally. Head of research Luke McMillan says the last two years has been a “really torrid time” for small cap investors both in Australia and globally.“You have to go back really a number of decades to see things be as bad as they’ve been for small cap investors and of course the precipitating factor was this rapid increase in interest rates,” he says.“That hit longer duration assets like longer duration bonds and when you’re talking about the equity market pretty much the longest duration assets are small cap growth orientated companies.”McMillan says this rate hiking cycle has hit small caps particularly hard with the underperformance of small caps versus larges caps in the US and Australia around 20%.He says while the S&P 500 and even Aussie large caps are making all time highs, the small cap variant which is the Russell 2000 in the US and S&P ASX Small Ordinaries, are still both down about 20% from their highs.“Historically, it’s really rare to see that bigger difference and normally even if we look at the worst part of business cycles which is recessions typically small caps underperform large caps by around about 5% on average,” he says.“So even though we haven’t had a recession this time you’ve still got this outsized underperformance of small caps which is bigger than any recessionary period going back the last five or six recessions in the US.”However, McMillan says the good news for small cap investors is it looks like central banks in key advanced economies are largely done with hiking rates.“If you believe market pricing they’re all done hiking rates now there might be a little bit of residual risk, we might have one more in some regions, but on the balance of probabilities it looks like they’re done,” he says.“Also we seem to have peaked out in terms of long term interest rates in those advanced economies so that big headwind for valuations looks like it’s largely done slamming small caps over the head.”Cheap valuations for small caps present opportunitiesMcMillan says further good news is we’re now starting from cheap valuations with small caps on an absolute and relative basis compared to large caps.“We’re seeing valuations the cheapest they’ve been in at least 15 or 20 years, ” he says.Furthermore, he says higher wages growth – also a headwind for smaller caps – appears to be stabilising.“Smaller cap companies seem to have a higher proportion of their costs in wages and just like inflation has been coming down it looks like we’ve seen a peak in wages growth as well, so that is another good news story heading into this year,” he says.However, McMillan says the residual risk is that while markets tended to rally in the last couple of months of 2023 on a higher probability of a soft landing and no recession in the US and Australia, we are “not out of the woods” with that probability still elevated.“If we do get a recession there is undoubtedly will be more downsize for equity markets, including small caps,” he says.McMillan says normally small caps do fall more than larger caps in a recession but it seems to be small caps have this time priced probability of a recession higher than large caps.“In fact particularly if we look at the US even if we consider that bear case and do get a recession we may actually see small caps not fall as much as large caps because they seem to be pricing it more and are much cheaper,” he says.“The last time we saw a recession where small caps didn’t fall as much as large caps was back in the dot.com bubble associated recession.“It had similar characteristics where large were a lot more expensive than small caps so they fell more.”Money to trickle back to small capsLast week an unexpectedly high inflation reading in the US sent jitters through markets. Consumer prices in the US picked up again in December to 3.4% (from 3.1% in November), driven by increases in costs for housing, dining out and car insurance.McMillan says it may be a bumpy ride still with work to firmly control inflation in the US and elsewhere but if it can continue to decline without much of an uptick in unemployment and no recession, then it’s likely we’ve seen the lows for equity markets.“This liquidity discount where people are taking money out of small caps and hiding in large caps you’ll start see that money start to trickle back down the market cap spectrum’ we think’ and have that catch-up period of out performance for small caps,” he says.McMillan says usually its part-way through a recession the market looks ahead to earnings recovery and will tend to recover before a recession is over.“Then you will get the period of small cap catch up or outperformance of large caps,” he says.“The average recession tends to go for nine to 10 months and this might be a milder one, more like the six-month variety, and the market starts rallying partway through.”2024 the year for small cap recoveryRed Leaf Securities CEO John Athanasiou told * he is confident of a positive year for ASX and global small caps.“2024 will be the year of the small cap recovery,” he says.“After two tough years for the sector due to in a rising cash rate environment, small caps are poised to recover as cash rates start falling which reduces the cost of financing which in turn increases investors risk appetite.“It is perfect conditions for a small cap recovery.”
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