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Small-cap ASX shares have generally underperformed their larger counterparts in recent years, and the increase in interest rates since the Reserve Bank of Australia (RBA) initiated its tightening cycle in May 2022 has not provided any relief. Starting with an official cash rate of 0.10% on May 3, 2022, the RBA implemented 10 consecutive monthly interest rate hikes, bringing the rate to 0.35% by May 4, 2022.
Since May 6, 2022, the S&P/ASX 200 Index (ASX:XJO) has gained 3.7% (excluding dividends). In contrast, the S&P/ASX Small Ordinaries Index (ASX:XSO), representing 200 companies excluding the largest 100 from the ASX 200, has experienced a loss of 8.3%.
While some smaller stocks have delivered significant returns, the overall performance of ASX small-cap shares raises questions about their future prospects. With expectations of declining interest rates in Australia and other developed nations in 2024, there is speculation about whether small-cap ASX shares will stage a comeback. Andy Gracey, portfolio manager of the Emerging Companies and the Australian Shares Fund at Australian Ethical Investment, provided insights into this possibility.
Gracey expressed optimism about the outlook for domestic inflation and interest rates, noting that the market anticipates the RBA to cut interest rates in the second half of 2024 and into 2025. He highlighted the attractiveness of risk assets like property and shares with lower rates on the horizon, which has already benefited large-cap and ASX 100 companies. Gracey suggested that there could be outperformance ahead for small-cap ASX shares in 2024, especially for microcap companies that have underperformed in recent years.
However, Gracey also raised cautionary points. He indicated that persistent inflation could pose challenges, and interest rates might not return to earlier decade levels. Company valuations, particularly a 25% price-to-earnings premium for small companies compared to the ASX 200, present challenges in finding compelling value, especially outside the materials and financial sectors.
Gracey acknowledged the benefits of investing in small-cap ASX shares, citing potential superior capital growth over the long term. Small companies, being more focused and specialized, offer better revenue and profit growth compared to blue-chips. Additionally, small-cap shares are more likely to be targets for private equity and strategic buyers.
On the flip side, Gracey cautioned about the risks associated with small-cap investments. These companies may experience more volatile trading updates and share prices, as they are typically more vulnerable to macro, regulatory, and industry challenges. Liquidity challenges in trading, especially for microcap companies, have been observed as investors depart from this segment of the market.
In conclusion, while there is optimism for a potential rebound in small-cap ASX shares in 2024 due to anticipated interest rate cuts, the challenges posed by inflation, company valuations, and market volatility should be carefully considered by investors.
