Small caps renaissance set to highlight the value of active management: Invesco

As the Reserve Bank of Australia loosens its grip on aggressive monetary policy and inflation headwinds begin to abate, the upside advantages of careful investment in small companies will gain prominence according to the latest insights from the team at Invesco.

Most economists put forward that inflation in Australia has followed that of the US in reaching its plateau, and will retreat by several quarterly basis points before the end of 2024, bringing with it cash rate guidance and freeing up some of the investment capital locked away by two years of prohibitive economic conditions.

Those conditions have inhibited smaller companies in Australia since the RBA started its rate hiking cycle, creating an atmosphere Invesco characterised as “challenged”. The nation’s central bank raised interest rates 13 times in the two years leading up to December 2023 in an effort to dampen inflation, which ran so hot it took all 13 of those increases to bring it heading back to the RBA’s target range. One side effect of this, however, was that it put a disproportionate amount of pressure on small companied compared to their larger counterparts.

It wasn’t Westpac, BHP and Telstra that suffered due to a lack of capital investment in 2022 and 2023, it was the fledgling companies on the edge of the ASX300 that depended on an open market that had both fully recovered from the pandemic and consumers that had money to spend on goods and services.

“Smaller companies are [also] typically more sensitive to the domestic economy and typically have more debt than larger companies.”

But opening up the economy with softer rates should facilitate the flow of capital back into a sector that presents as both undervalued and underinvested, Invesco believes.

“At the end of 2023, we have a much more stable economic environment with falling inflation and more dovish policy settings from central banks globally,” Invesco stated. “Looking at the business cycle in more detail, our own proprietary models suggest that globally we are entering the ‘recovery phase’ of the business cycle.

Historically, this recovery phase has always been more supportive for smaller companies with cyclical exposure, high operating leverage and high sensitivity to growth expectations. “These characteristics are typically found in smaller companies as opposed to larger companies,” Invesco added.

While the opportunity set for small companies looks promising, this prospect is heightened when active management is thrown into the mix, Invesco put forward, “because of the ability to access diverse business models and the ability to avoid investing in poor performers such as highly speculative companies”.

There are fundamental advantages to the sector, as well, with the greater number of small companies meaning the underlying index represents a more diverse and less concentrated cohort of entities than the top end of the ASX.

“When we look at smaller companies using the S&P/ASX Small Ordinaries index we see that it is over five times more diversified that the larger companies exposure of the S&PASX/100,” Invesco noted.