CRITERION: Small cap fruits look about ripe for picking

Small-cap stocks have significantly underperformed their larger brethren since the pandemic-era stimulus taps were turned off, leaving many of them struggling for funds.

That’s good news as well, because history shows this situation will not last.

The last time the sector did worse was in 1938, LGT Crestone senior investment analyst Jessica Clifford told a recent Financial Times small-caps seminar.

Post-war, the small caps have outperformed the large caps many times over.

ANZ Private Bank portfolio manager Samantha Chien concurs: “small caps are the first to pop when there is any indication of stronger economic conditions”.

While all companies are vulnerable to interest rates, inflation and softening consumer demand, small caps are more so because of their weaker balance sheets, lack of access to debt capital and greater exposure to the domestic economy.

Chris Chen, senior investment director with American Century Investments notes that “small caps have had a rough couple of years” regardless of the region.

“But inflation appears to be coming off,” he says. “Growth is not out of the woods but the risk of a hard landing appears to be lower than 12 months ago.”

Okay – the macro picture is supportive. But how do investors pick a specific winner such as US-oriented family security mob Life 360 (ASX:360), which has doubled in value over the past year? Or how about buy-now-pay-later Lazarus stock Zipco (ASX:ZIP), which has tripled in value?

The gurus suggest a starting point of companies with a decent balance sheet and solid earnings. If they are not making money, they should have the potential to be a disruptive force in their sector and should not trade on excessive blue-sky valuations.

“We want quality balance sheets and management but … we also want earnings acceleration,” Chen says.

Drummond Capital Partners’ Nick Shoenmaker says investors have been led to believe that the megacaps – especially the US tech leaders – are forever onwards and upwards.

While the US ‘Magnificent Seven’ tech stocks have ridden the AI boom, the small caps need not miss out with opportunities in related sectors such as data centres, software-as-a-service, 5G, cybersecurity providers and energy infrastructure owners.

Meanwhile, non-AI “megatrends” include defence, real estate, critical minerals and tourism.

Scarce analyst coverage opens an opportunity for active stock pickers to trawl the small caps flying under the analytical radar and prone to mispricing (accentuated by low liquidity).

Given this lack of scrutiny, the upcoming domestic profit-reporting season has the capacity to produce surprises – with those conveying the nasty ones tending to lob last-minute accounts.

RBC Capital Markest expects decent numbers from ZIP (post a balance-sheet repair job) and Siteminder (ASX:SDR), a portal for hotels to fill vacant rooms.

The firm also likes online retailer Temple & Webster (ASX:TPW).

Given that several retailers including Universal Store (ASX:UNI) have pointed to better times, we would pay special attention to marked-down merchants such as Kogan (ASX:KGN), Super Retail Group (ASX:SUL), Dusk Group (ASX:DSK) and – for the brave – City Chic Collective (ASX:CCX) and Cettire (ASX:CTT).

Tyndall Asset Management’s James Nguyen also likes Zipco – there’s a trend happening here – as well as the travel portal Webjet and the ferry/bus operator Kelsian (ASX:KLS, formerly Sealink).

Webjet is in the throes of demerging its flight and accommodation booking arms, with a view to completion by the end of the year.

Kelsian is an ‘all aboard’ opportunity given its shares have declined around 25 per in the past year, although its May update refers to cost of living pressures and absentee bus drivers.

Of course, many small caps are small for a reason. Then again, many large caps used to be small ’uns and the average value of the sector is increasing.

This story does not constitute financial product advice. You should consider obtaining independent advice before making any financial decision.

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