Fundies position for a strong 2023 ASX small cap comeback

ASX small caps hit harder by macroeconomic headwinds, underperforming large caps
As inflation eases, fundies forecast a resurgent 2023 for ASX small caps
Datt Capital believes market timing is opportune to uncover alpha in the small caps space

Could 2023 be the year of an ASX small caps comeback?

Talking to the fundies who bring home our MoneyTalks column recently, there appears to be signs for optimism in the ASX small caps sector – which has had one of its more meagre periods in terms of relative performance vs ASX large caps over the past two decades.

The smaller end of the market is still underperforming its large capscounterpart, but just like the Aussie battlers they are, the index is showing signs of resilience.

The S&P/ASX Small Ordinaries is up ~3.70% YTD, while the S&P/ASX Emerging Companies Index is modestly up ~1.08% for the same period, while the benchmark S&P/ASX 200 is up ~4.58%.

READ: ASX April Winners – Mid and small caps outperform blue-chip peers as gold stocks keep up rally

“Small caps have had a particular challenging period and if you look back through calendar year 2022 small caps had their second worst year in two decades against in large caps in terms of performance and 2023 has kicked of in a similar way,” according to Tribeca Investment Partners portfolio manager Simon Brown.

Brown puts it this way – ASX smaller caps have greater exposure to areas which have endured the deleterious effects of challenging macroeconomic conditions – those which have run amok over the last several quarters, such as the higher inflation, the uncertainty and the inevitable interest rate hikes that have followed.

Some sectors have naturally been more exposed than others.

“Consumer discretionary is a reasonably large part of small caps and that has been a more challenging sector as interest rates have been rising… There’s building materials and higher rates has seen housing turnover come down as mortgage costs go up.”

“Analysts have had to adjust their forecasts down and share prices can often follow EPS changes.”

He said inflation has also seen more earnings downgrades for ASX small caps compared to their larger peers.

“When we look under the hood a lot of that has come through in margins and when we think about it cost inflation has been prevalent right through the economy.”

To the Tribeca team, it’s been evident that larger caps have been able to pass through these costs better than smaller cap companies.

This is because larger caps tend to operate in consolidated sectors and have lots of pricing power and so can pass on higher prices a lot of the time without consequence.

“We think about the supermarkets, where you have the two big majors, the big four banks, toll road sectors,” he told Stockhead.

“They are very large businesses and there’s not too many of them.”

Furthermore there’s a lot of domestic generated earnings in the ASX small caps sector, whereas in larger caps a lot more offshore earnings in non-Australian denominated currencies.

“The fall in the Australian dollar has helped the translation effect of a lot of those earnings in larger companies with offshore operations that have enabled them to hold up better than some of the domestic focused companies.”

Catch a falling star

Brown said as inflation starts to fall, albeit slowly, the cost pressures may start to abate for many ASX small caps in 2023 and earnings downgrades, margins pressures we’ve seen over the past 15 months or so will start to ease.

He said while there has been some mixed messaging from the Reserve Bank of Australia (RBA) in terms in this interest rate tightening cycle it does feel like we are more at the end than beginning.

“We might see some relief from the consumer and maybe a bit more confidence once interest rates start to plateau for investors once they know what their costs of capital and debt is going to be with confidence to start investing again return,” he said.

Brown said as “style neutral fund” they have a relative flexible approach to stocks they invest in and the attractiveness of small caps is growth potential.

“We are always asking ourselves can this business grow their earnings and often in small caps they can be higher growth because they’re mostly coming off a smaller earnings base,” he said.

“It’s easier to grow earnings quite quickly as opposed to a large company with a large earning base – it’s just the law of small and large numbers.”

He said Tribeca looks for management teams fit for purpose and capable of delivering growth they think a business can achieve.

“We have a valuation approach that sets our expectations for share price upside and conviction in that upside,” he added.

The Tribeca Australian Smaller Companies Fund was recently upgraded to a recommended rating from research house Zenith Investment Partners.

In its report, Zenith said that its conviction in the fund “is centred on the investment capabilities and experience of the senior investment team members” reasoning that the “strong, positive trajectory” in the strategy’s asset base is viewed with positively,

“Overall, Zenith believes the Fund is well-placed to meet its investment objectives.”

Datt Capital to launch Aussie small caps fund

Aussie equity investment manager Datt Capital also believes the market timing is opportune to uncover alpha in the ASX small caps space in 2023 and is planning to launch a fund in the sector.

Chief investment officer Emanuel Datt said following heavy sell downs there are now good opportunities to acquire sustainable businesses across various industry sectors where the upside potential far outweighs the downside risk.

“Many of these small caps, which offer investors access to earlier-stage, higher-growth businesses, are currently trading on single-digit earnings multiples, and, as such, present a compelling investment story,” he said.

“It is significant that the Future Fund has publicly declared it is increasing its exposure to small-caps exposure via active managers.”

He says that although small-cap investments inherently carry more significant risks than large-cap stocks, academic research supports the idea of a small-cap premium offering outsized alpha.

“The small-cap market is often less efficient than its large-cap counterpart, providing a higher probability of uncovering alpha due to limited analyst and investor attention.”

He said that their small cap fund, which will target early-stage investors, will build on the demonstrable active fund management gleaned over the past five year track record set by the Datt Capital Absolute Return Fund.

“To maximise the chances of capturing alpha, we consider diversification, risk management, trading costs, the benefits of active management, research and monitoring,” he said.

READ: MoneyTalks – Three stocks to watch from the ‘deeply discounted’ ASX Small Industrials

The views, information, or opinions expressed in the interviews in this article are solely those of the interviewee and do not represent the views of Stockhead.Stockhead does not provide, endorse or otherwise assume responsibility for any financial product advice contained in this article.