ASX small caps: Where we see opportunity in data centre and consumer stocks

Looking beyond the headlines, selective small-cap exposure can still uncover quality businesses. DAMIEN DIAMANT explains where the Pendal small caps team is finding opportunities

• Resilient small caps can outperform market noise
• Selective stock picking uncovers quality opportunities
• Find out about the Pendal Smaller Companies Fund

SMALL CAPS provide a chance for ASX investors to diversify portfolios away from the large caps that dominate the top end of town.

They are often driven by very different themes to the macro factors that typically affect the ASX100.

Examples include successful technology businesses, category leading retailers and companies producing materials used in batteries such as lithium, cobalt and nickel.

One sector that’s attracting the attention of Pendal’s small cap team at the moment is consumer discretionary – though it requires a well-resourced, active manager to identify potential winners in a segment that has lagged others.

The sector spans specialty retail, housing-related retail, travel, tourism, e-commerce, auto retail, gambling and fast food.

But tax changes, higher interest rates, rising fuel costs, and cost-of-living pressures are weighing on consumers’ disposable income.

While this creates downside risk for earnings, Pendal investment analyst Damien Diamant says it is not all bad news.

One tailwind is the currency benefit some companies may gain from a stronger Australian dollar against the US dollar.

“That will be a significant boost for retailers with strong control over their supply chains,” says Diamant.

“Another often overlooked point is that the balance sheets of Australian consumer stocks are very healthy, particularly compared with some US-listed peers.

“Most retailers are in net cash positions, so they can weather softer periods.”

What to look for

Diamant says identifying companies that are “ripe for stock picking” requires extensive research to find those with stronger business models.

“There are many different business models in this space, so we need to do the hard work to understand them, which we’ve done over many years,” says Diamant.

“We’ve spent significant time with management teams to understand their businesses, competitive dynamics, and the strengths and weaknesses of each model.”

Diamant says that the profile of the small ordinaries index has changed materially over the years, the consumer discretionary sector made up about 20 per cent of the ASX Small Ordinaries Index a few years ago. Today, it accounts for about 10 per cent.

“That shows how much the sector has struggled, especially relative to stronger-performing areas such as resources, particularly gold, as well as emerging sectors like defence and some contractors,” he says.

With the Australian economy still heavily consumer-driven, as in the US, the sector remains an important part of the market.

The Pendal small caps team focuses on businesses that are more resilient, have stronger management teams, and can deliver earnings growth and returns on capital over time.

Some examples of consumer discretionary stocks that feature in the small caps portfolio include furniture retailer Nick Scali, Premier Investments – owner of sleepwear retailer Peter Alexander and fun stationery retail chain Smiggle, fashion company Universal Store and home appliance specialist Breville Group.

The small cap opportunity

While small caps underperformed large caps by more than 20 per cent in the four years to June 2025, that gap has reversed over the past year in favour of small caps.

The ASX Small Ordinaries Index has risen 13.2 per cent, while the ASX100 is up 9.9 per cent.

Industrials also offer attractive entry points, with the sector nearing its cheapest level relative to the ASX100 in the past decade.

Another theme creating opportunities is data centre growth driven by the rapid adoption of artificial intelligence.

Capital expenditure on data centre buildouts in Australia has risen sharply, alongside spending on the energy transition and defence.

Expected data centre capex to FY28 has surged to an estimated $75 billion[1], up from $8.7 billion[2] between FY21 and FY24. Over the same period, estimated aggregate revenue for DC-adjacent small caps has quadrupled to $3.4 billion[3].

Meanwhile, spending on the energy transition and defence is expected to grow by 10.9 per cent and 13.2 per cent respectively over the five years to FY30[4].

Find out about

Pendal Smaller Companies Fund

Patrick Teodorowski & Lewis Edgley,
Portfolio Managers

Learn more

The limited beneficiaries of CGT changes

Proposed changes to capital gains tax and negative gearing in the recent federal budget are set to affect certain investments, particularly property. However, Diamant says one area likely to become more attractive is investment bonds.

An investment bond is an investment linked life insurance structure that can hold assets across various classes, including Australian equities. If held for more than 10 years, no capital gains tax is payable.

“Investment bonds have been untouched by the budget, and from a relative perspective they have become a much more attractive tax structure,” says Diamant.

Generation Development Group subsidiary Generation Life is particularly active in this area, and Diamant believes the company will gain traction through its investment bond business, which contributes approximately 40 per cent of group profits.

“GenLife is the market leader in this space. It currently accounts for 60 per cent of industry flows,” says Diamant.

“There are three key players in this market, and GenLife is investing the most in improving and broadening its product range, including access to more investible assets. It is also committing more resources to growing its sales team and promoting the offering.”

Building portfolios for multiple scenarios

During periods of volatility and equity rotation, it is important to build a portfolio that can add value across multiple scenarios, according to Diamant.

The small caps team looks for investments across four key areas: strong free cash generation, franchise winners, disruption, and structural tailwinds.

Channel Infrastructure NZ, for example, falls into the strong free cash generation category, while electrical contractor Southern Cross Electrical Engineering and diversified construction contractor NRW Holdings are exposed to the DC buildout tailwinds.

The Pendal Smaller Companies Fund has a position in these three companies.

[1] Pendal estimates

[2] Morgan Stanley as at 25 March 2026

[3] FactSet and Pendal estimates for NWH-ASX, SXE-ASX, IPG-ASX, MYG-ASX, SKS-ASX

[4] Morgan Stanley as at 25 March 2026. Pendal estimates.