Why ASX-listed small caps look set to outperform

Looming rate cuts are making ASX-listed smaller companies more attractive, argues Pendal portfolio manager LEWIS EDGLEY

• Small caps buoyed by rate cuts
• Careful stock selection matters
• Find out about the Pendal Smaller Companies Fund

THE prospect of rate cuts over the remainder of 2025 should buoy small cap stocks, says Pendal portfolio manager Lewis Edgley.

Markets are increasingly confident that falling interest rates over the next 12 months will help Australia avoid a prolonged economic downturn, assisted by strong employment and continued immigration.

That kind of macro-economic background has traditionally been positive for small caps, which are more cyclical and growth-oriented than their larger counterparts and hence tend to outperform during periods of monetary easing.

“We know from experience that when rates go down, small caps, as a category, tend to outperform large caps,” says Edgley.

“So, if we believe that there’s not going to be a recession but there is going to be a rate cutting cycle, then running a small cap fund is going to go from feeling like we’ve been driving with a hand brake on the last few years to letting the hand brake off and maybe even getting a bit of a wind behind us.”

Edgley and fellow portfolio manager Patrick Teodorowski co-manage the Pendal Smaller Companies Fund, an actively managed portfolio investing in companies outside the top 100 in Australia and NZ.

Stock selection matters

Edgley says investors are often turned off small caps due to the poor performance of the benchmark ASX Small Ordinaries Index, which has returned 5.4 per cent a year over the past two decades, well below the S&P ASX 100’s 8.8 per cent return.

But the headline performance disguises the fact that the median small cap manager returned 11.15 per cent a year over the same period.

“Small cap investing requires time and resources and the index returns have been lower than large caps,” he says.

“But if you do it well, there’s a huge opportunity to add value and beat the broader market return, while benefiting from diversification.

“We tell people, focus on earnings, not on macro — that’s where you make money in smalls.”

Beware cheap stocks

Edgley says from a valuation perspective, small caps are currently trading in line with their large cap counterparts, despite historically trading at an 8 to 10 per cent premium.

“So, you could say small caps are a bit cheap, and maybe that’s a good time to buy.”

But he cautions that low valuations can be misleading.

“Don’t be allured into buying cheap stocks. Because they’re often cheap for a reason. Might be a bad management team, might be a poor industry, might be a poor capital structure.

“We’ve made money out of cheap stocks in the past, but we’ve also made money out of buying expensive stocks that get more expensive.

“The key is to focus on earnings – if you get that right, you make money.”

Why earnings matter: Breville vs Myer

Edgley says a striking example of the power of focusing on earnings is the long divergence between two household names: Breville and Myer, both of which are held within the small-caps portfolio.

In the 1970s, both were regarded as standout businesses. Each offered exposure to the Australian consumer, and both were widely seen as credible, reliable options for discretionary spending.

But over the decades, their fortunes have sharply diverged.

Breville has consistently innovated and delivered on what consumers want, from the 70s cult hit Melitta drip coffee machine to today’s fully automated espresso stations. That has delivered sustained earnings growth.

“As an investor 15 years ago, you probably would have thought Myer was the bigger, seemingly more credible, safer business to invest in than Breville,” says Edgley.

“But look what happened. Breville has had a five times increase in its earnings per share over this period, whereas Myer’s earnings have faced significant challenges, down almost 90%.”

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However, Edgley notes that Myer is currently embarking on a “self-help” journey, which presents a potential opportunity for improvement.

“While Myer has had a tough history, we see a scenario where they could materially improve their earnings through a number of cost and productivity-related improvements that aren’t necessarily understood or captured in today’s share price,” he says.

“This reinforces the point that small caps are all about understanding earnings.”

According to Edgley, both Breville and Myer present as interesting investment prospects today.

“Breville continues to have a robust outlook as it innovates and grows into new markets globally while carefully navigating the short-term uncertainties of US tariffs, while Myer has the potential to significantly improve its earnings through strategic internal changes.

“Understanding these dynamics is key to making informed investment decisions in the small cap space.”