A boutique fund manager said the recent underperformance of Australian small caps compared to their larger peers was likely to reverse, positioning the asset class as an attractive opportunity for investors “right now”.

In its latest research, Prime Value Asset Management said that over the past three years, small-caps have underperformed large-caps by roughly 10 percent annually — a level of disparity last seen between 2013 and 2015.

Citing data from Morningstar, Prime Value said Australian small-cap managers had net retail outflows totaling $2.6 billion over the past three years, reflecting investor hesitancy amid the sector’s struggles.

This lackluster performance was driven by two major headwinds: the broad impact of rising interest rates, which disproportionately affected small caps, and the relative decline in earnings performance compared to large caps. However, both challenges are now expected to turn into a tailwind, potentially fueling a small-cap resurgence.

"Given the reasons for the underperformance in recent years, the likelihood of this reversing, and the small-cap valuation support relative to history, we see an ongoing opportunity to allocate to high-quality Australian small-caps," the report said.

Historically, stocks have tended to rise during periods of falling interest rates, with the exception of periods of severe economic recession. According to the paper, small-cap companies are particularly well-positioned to outperform their larger peers in such environments.

The report highlights several factors underlying the strong correlation between falling interest rates and the outperformance of small markets, suggesting favorable conditions ahead for this segment of the market.

The first factor is lower borrowing costs, as smaller businesses tend to rely more on external financing and are more sensitive to fluctuating interest rates. Lower interest rates generally improve smaller companies' access to debt markets, reducing their financial constraints and supporting growth opportunities.

Second, lower interest rates increase the present value of future earnings, making small-cap companies—often early-stage and growth-oriented—more attractive to investors. In addition, their flexibility allows them to take advantage of reduced borrowing costs and favorable economic conditions more quickly than larger, more bureaucratic firms.

Superior earnings growth

Prime Value said small-cap earnings growth has historically been more sensitive to even modest market share gains, which have a bigger impact than large-caps. In addition, small-cap companies often operate in niche industries, providing greater operational diversity and unique growth opportunities.

"This generally indicates that small-caps grow their earnings more strongly than large-caps in favorable market conditions and, conversely, suffer larger declines in earnings in weaker market conditions," according to the paper.

Prime Value analyzed small capital constraints over the past decade, dividing the period into the 'pre-Covid years' (2013-19) and the 'Covid years' (2019-23). The analysis found that earnings growth (EPS) of small-cap stocks outperformed large-caps in pre-COVID-19 years and underperformed in post-COVID-19 years.

"However, equity markets are looking ahead and consensus estimates are once again projecting stronger EPS growth for small caps versus large caps over the medium term as the economy normalizes post-Covid," Prime Value said.

Separately, Australian small-caps offer greater diversification than large-caps, and small-cap managers consistently generate alpha, according to the paper.

Smaller companies also provide an opportunity to invest in a wider range of the economy.

"A key argument for investing in small caps is the success small-cap active managers have in generating consistent alpha," the report said.

"This is a function of the relative inefficiency of the small-cap market, such as lower liquidity and less analyst coverage, combined with stronger earnings growth and a more fragmented index composition."

Managers can also differentiate their performance from the index through portfolio construction, as the dispersion of returns remains much wider in small-cap stocks.

"While there are high-growth companies that deliver huge returns, there are also companies that significantly underperform or fail altogether," it said.