Australian small companies are often treated as an afterthought in portfolio construction, a satellite allocation with high beta (added when markets feel buoyant and trimmed at the first sign of trouble). The current starting point is perhaps a little different as we are quite well advanced in a global, AI driven bull market but local small companies have been a bit of a backwater. That means local small caps play a different structural role in a diversified multi-asset portfolio.

A genuinely different opportunity set

The S&P/ASX Small Ordinaries is not simply a miniature version of the ASX 100. Where the large-cap index is dominated by banks and diversified miners, the small-cap universe offers exposure to themes largely absent at the top end of the market: mining services, electrification, asset managers, specialist financials and infrastructure connected to the data centre and defence capex cycle. Resources now represent around 31% of the Small Ordinaries benchmark, and gold stocks alone account for roughly a third of the index's forward earnings. Adding small caps therefore diversifies the drivers of equity returns, not just the number of holdings.

Fertile ground for active management

In this week’s What We Are Working on video with Ben Griffiths of Eley Griffiths Group we discuss why they believe the companies in their Emerging Companies Fund (largely micro caps) are less researched and less efficiently priced than blue chips, which makes stock selection more rewarding. The Fund has generated around 14% per annum since its 2017 inception compared to about half that for the Small Ordinaries Accumulation Index, a difference driven principally by stock selection and nimble positioning rather than concentrated bets. Many similar funds with comparable track records have added value in a more episodic manner but this style-agnostic approach, which rotates between growth and value as the earnings cycle shifts, has made the strategy easier to hold through a full cycle. 

A cyclical case on top of the structural one

That said the asset class and the fund have had a tough year compared to the ASX 20 and Ben makes a compelling case that this has been largely due to liquidity, or the absence of it flowing towards smaller Aussie companies. This corroborates quite well with other sources that we follow including Hunt Economics and also means that the starting point, from a valuation point of view, is arguably better in this cycle.  

Australian small caps have underperformed large caps by more than 35% since the rate-hiking cycle began in September 2021, with that underperformance closely correlated to interest rate expectations. Small industrials currently trade at a 10% price-earnings discount to their large-cap counterparts, in line with the 15-year average of 12%, reasonable value after an extended drought. Meanwhile, relative earnings revisions have swung back in favour of small companies, historically a precursor to periods of outperformance.

Managing the risks

None of this is a free lunch. Small-cap indices carry annualised volatility of around 21%, benchmark composition can become lopsided (the current gold concentration being a case in point), and individual companies fail more often than large ones. We think this is one area where a risk-managed, actively selected exposure rather than passive index ownership can work. You also need to size the allocation so that drawdowns do not force selling at the wrong moment.

The portfolio role

In a multi-asset context, Australian small caps are best framed as a return-enhancing satellite to core equity holdings: typically a modest single-digit weighting funded from large-cap equities, complementing traditional value and growth allocations and rebalanced with discipline. The reward is access to a broader set of earnings drivers, a richer hunting ground for alpha. At current valuations there may be a case for a higher allocation than one would typically have if you thought we were late in the cycle.