The case for small caps: why small companies are set to outperform

Pendal

May 2025

THE prospect of rate cuts over the remainder of 2025 should buoy small cap stocks, says Pendal portfolio manager Lewis Edgley.

Markets are increasingly confident that falling interest rates over the next 12 months will help Australia avoid a prolonged economic downturn, assisted by strong employment and continued immigration.

That kind of macro-economic background has traditionally been positive for small caps, which are more cyclical and growth-oriented than their larger counterparts and hence tend to outperform during periods of monetary easing.

"We know from experience that when rates go down, small caps, as a category, tend to outperform large caps," says Edgley.

"So, if we believe that there's not going to be a recession but there is going to be a rate cutting cycle, then running a small cap fund is going to go from feeling like we've been driving with a hand brake on the last few years to letting the hand brake off and maybe even getting a bit of a wind behind us."

Edgley and fellow portfolio manager Patrick Teodorowski co-manage the Pendal Smaller Companies Fund, an actively managed portfolio investing in companies outside the top 100 in Australia and NZ.

Stock selection matters

Edgley says investors are often turned off small caps due to the poor performance of the benchmark ASX Small Ordinaries Index, which has returned 5.4 per cent a year over the past two decades, well below the S&P ASX 100's 8.8 per cent return.

But the headline performance disguises the fact that the median small cap manager returned 11.15 per cent a year over the same period.

"Small cap investing requires time and resources and the index returns have been lower than large caps," he says.

"But if you do it well, there's a huge opportunity to add value and beat the broader market return, while benefiting from diversification.

"We tell people, focus on earnings, not on macro -- that's where you make money in smalls."

Beware cheap stocks

Edgley says from a valuation perspective, small caps are currently trading in line with their large cap counterparts, despite historically trading at an 8 to 10 per cent premium.

"So, you could say small caps are a bit cheap, and maybe that's a good time to buy."

But he cautions that low valuations can be misleading.

"Don't be allured into buying cheap stocks. Because they're often cheap for a reason. Might be a bad management team, might be a poor industry, might be a poor capital structure.

"We've made money out of cheap stocks in the past, but we've also made money out of buying expensive stocks that get more expensive.

"The key is to focus on earnings - if you get that right, you make money."

Why earnings matter: Breville vs Myer

Edgley says a striking example of the power of focusing on earnings is the long divergence between two household names: Breville and Myer.

In the 1970s, both were regarded as standout businesses. Each offered exposure to the Australian consumer, and both were widely seen as credible, reliable options for discretionary spending.

But over the decades, their fortunes have sharply diverged.

Breville has consistently innovated and delivered on what consumers want, from the 70s cult hit Melitta drip coffee machine to today's fully automated espresso stations. That has delivered sustained earnings growth.

"As an investor 15 years ago, you probably would have thought Myer was the bigger, seemingly more credible, safer business to invest in than Breville," says Edgley.

"But look what happened. Breville has had a five times increase in its earnings per share over this period, whereas Myer's earnings have faced significant challenges, down almost 90%."

However, Edgley notes that Myer is currently embarking on a "self-help" journey, which presents a potential opportunity for improvement.

"While Myer has had a tough history, we see a scenario where they could materially improve their earnings through a number of cost and productivity-related improvements that aren't necessarily understood or captured in today's share price," he says.

"This reinforces the point that small caps are all about understanding earnings."

According to Edgley, both Breville and Myer present as interesting investment prospects today.

"Breville continues to have a robust outlook as it innovates and grows into new markets globally while carefully navigating the short-term uncertainties of US tariffs, while Myer has the potential to significantly improve its earnings through strategic internal changes.

"Understanding these dynamics is key to making informed investment decisions in the small cap space."

Author:  Lewis Edgley and Patrick Teodorowski

Funds operated by this manager:

 This information has been prepared by Pendal Fund Services Limited (PFSL) ABN 13 161 249 332, AFSL No 431426 and is current as at December 8, 2021. PFSL is the responsible entity and issuer of units in the Pendal Multi-Asset Target Return Fund (Fund) ARSN: 623 987 968. A product disclosure statement (PDS) is available for the Fund and can be obtained by calling 1300 346 821 or visiting www.pendalgroup.com. The Target Market Determination (TMD) for the Fund is available at www.pendalgroup.com/ddo. You should obtain and consider the PDS and the TMD before deciding whether to acquire, continue to hold or dispose of units in the Fund. An investment in the Fund or any of the funds referred to in this web page is subject to investment risk, including possible delays in repayment of withdrawal proceeds and loss of income and principal invested. This information is for general purposes only, should not be considered as a comprehensive statement on any matter and should not be relied upon as such. It has been prepared without taking into account any recipient's personal objectives, financial situation or needs. Because of this, recipients should, before acting on this information, consider its appropriateness having regard to their individual objectives, financial situation and needs. This information is not to be regarded as a securities recommendation. The information may contain material provided by third parties, is given in good faith and has been derived from sources believed to be accurate as at its issue date. While such material is published with necessary permission, and while all reasonable care has been taken to ensure that the information is complete and correct, to the maximum extent permitted by law neither PFSL nor any company in the Pendal group accepts any responsibility or liability for the accuracy or completeness of this information. Performance figures are calculated in accordance with the Financial Services Council (FSC) standards. Performance data (post-fee) assumes reinvestment of distributions and is calculated using exit prices, net of management costs. Performance data (pre-fee) is calculated by adding back management costs to the post-fee performance. Past performance is not a reliable indicator of future performance. Any projections are predictive only and should not be relied upon when making an investment decision or recommendation. Whilst we have used every effort to ensure that the assumptions on which the projections are based are reasonable, the projections may be based on incorrect assumptions or may not take into account known or unknown risks and uncertainties. The actual results may differ materially from these projections. For more information, please call Customer Relations on 1300 346 821 8am to 6pm (Sydney time) or visit our website www.pendalgroup.com

Market Commentary - April

Glenmore Asset Management

May 2025

Funds operated by this manager:

Glenmore Australian Equities Fund

Hedge Clippings | 16 May 2025

Consensus expectations from a significant majority of economists anticipate a 25 basis point cut next Tuesday when the RBA announces their decision following the new format 2-day board meeting. If the economists are correct - and the market is certainly backing that view - it will bring the cash rate to 3.85%. For example, the CBA is amongst the pack, forecasting a 25 basis point cut, with potential further cuts in August and November, aiming for a year-end rate of 3.35%.

Some analysts, like NAB's chief economist Sally Auld, suggest a more aggressive approach, proposing a 50 basis point cut in May, followed by additional reductions throughout the year, and potentially lowering the rate to 2.85% by December. ANZ has reportedly walked back from their previous call that the RBA would "definitely cut", now seemingly having a bet each way by suggesting there's around a 30% chance they'll stay on hold for at least another month.

As usual, there are arguments both for and against a move: Inflation at 2.4% (12 months to March) is firmly in the RBA's 2-3% target range, although that number remains skewed by government subsidies on electricity prices, which fell 9.6%. The RBA's preferred trimmed mean measure is a tad higher at 2.7%, but still within the band. More recent CPI figures for April aren't due until the week after the RBA meets, but it would be surprising if it kicked up above 3% to spoil Albo and Jim Chalmers' post election party.

Against that, Australia's labour market remains tight, with a notable increase of 89,000 jobs in April and a steady unemployment rate of 4.1%. Such strength could lead to wage pressures, potentially reigniting inflation, and Michele Bullock has previously pointed to this as a risk, preferring to see a number above 4.5%.

The RBA has previously cited "uncertainty" as a significant reason for their reluctance to ease further, or earlier, and while the local political outlook now seems stable, uncertainty definitely persists despite an apparent easing of the tariff tit-for-tat between the US and China in particular. However, it is only an easing from the trade-stopping proposed levels of 145% and 125%, down to a US tariff of 30%, and a reciprocal tariff of 10% from China.

That level of uncertainty may, or may not, impact the RBA's decision-making process, but it remains a major concern for the US itself, where the FED's Jerome Powell is standing firm against both Trump's threats and insults, and a decision on cutting rates from their current 4.25% to 4.50% level.  The market had expected a cut at the FED's June meeting, but this has now been pushed out to July or possibly September. Looking further out, the market is still not convinced US rates will be much below 4% by December, and if Trump's tariffs lead to inflation kicking up (and it seems difficult to imagine why it would not, even at the new lower tariff levels) then maybe Powell's stance will be vindicated.

That leads to another dilemma (or effect) on Australia and the RBA. If NAB's forecast of Australian rates of 2.85% by December is correct, and a worst-case scenario of 4% or more in the US, what does that do to the Aussie dollar?  Meanwhile, while the chances of a recession might seem slim in Australia, the US economy is heading into uncharted Trump-induced waters. Slowing economic activity and consumer confidence in the US may force Powell to cut, leading to two significantly different policy decisions.

In the meantime, next Tuesday afternoon's RBA announcement, due at 2:30 looms large. At 3:30 Michele Bullock will hold her traditional media conference. Hedge Clippings and Australian Fund Monitors have organised a webinar at 4:30 immediately after the Governor finishes her address to discuss the outcome of the meeting and, more importantly, the outlook for both Australia's markets, and the Global economy.

We have assembled three expert fund managers to discuss, debate and share their views. Please register below to join the Zoom webinar, which should last between 30 to 45 minutes and will include a Q&A. Our guest panel of fund managers will be:

• Nick Chaplin, Portfolio Manager, Seed Funds Management - Hybrid Securities, Bonds and Fixed Interest.
• Winston Sammut, Portfolio Manager, Euree Asset Management - Property and Multi-Assets.
• Alex Pollak, CIO and Founder, Loftus Peak Global Disruption Fund.

Each of our expert panel members will bring a different perspective, and we look forward to hearing from them.

Registration is required - please click here or below.

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