4 reasons to stick with battered small-cap ASX shares

Is it horrifying to look at your smaller-cap stocks right now? Here’s a pep talk to get you through a rough 2022.

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Investors who hold small-cap ASX shares have watched in horror this year as their investments turned to a sea of red.

And it’s not just paranoia — their underperformance is shown in the numbers. 

The S&P/ASX Small Ordinaries (ASX: XSO) is down about 27% so far this year, while its large-cap sibling the S&P/ASX 200 Index (ASX: XJO) has fallen only half that amount.

The team at Ophir Asset Management, which has traditionally favoured the smaller segment of the market, admitted 2022 has been a vomit-inducing ride.

“There is no doubt that in this tough market investors are seeing the downsides of small caps – greater volatility, less liquidity and bigger falls,” they said in a recent memo.

Sliding markets, like right now, are a test of nerve and patience for investors, according to Ophir analysts.

“They can also reveal what an investor’s true risk tolerance is, compared to what may be stated during much calmer investment waters,” read their memo.

“[But] by this stage it is often too late if an investor hasn’t ‘right-sized’ their allocation to small caps.”

It’s only human nature that some investors would be “questioning why they should bother” holding small-cap ASX shares.

To settle those nerves, the Ophir team put up four reasons why it’s worth holding on to the little guys through stormy seas:

1. Conditions have never been better for the little battler

Never in history have we been in a period where a small company with a great idea has such an opportunity to seriously disrupt larger incumbents.

Technology and globalisation have played a massive role in making it easier for smaller fish to challenge the big fish.

“Many businesses are software-based and they can be scaled to a global audience,” read the Ophir memo.

“Video conferencing technology and real-time supply-chain management solutions mean a CEO can run a manufacturing business scattered throughout the world.”

Governments and authorities have also become more savvy in regulating for competitive markets.

“Back in the late 19th century in the US, the largest companies were often controlled by the so-called ‘robber barons’, who created powerful monopolies in their industries from real estate, railroads and finance to steel and oil,” stated the Ophir team.

“Over time, policymakers and regulators increasingly recognised that competition benefited consumers and the playing field started to change.”

The leaders of tomorrow will come from small caps, according to Ophir.

“Investors who find these companies early can earn big returns before the company becomes a mature industry leader and known to the masses.”

2. Small caps have historically rewarded investors

Speaking of big returns, the Ophir team’s second point was that smaller companies have traditionally provided higher returns to investors over the long run.

“Amazingly, since 1926 in the US, US$1 invested in large caps grew to US$5,767 dollars by the end of 2017,” read the memo.

“But if it was invested in small caps it grew to a staggering US$38,842.”

But expectations must be set about the investment horizon.

“Though it is reasonable to assume that small-cap investors will continue to earn a premium because of small caps’ riskier nature, this may not occur over all periods,” said the Ophir team.

“There have been periods of 10 to 20 years where small caps have underperformed large caps, including in Australia.”

3. Finding mispricing opportunities is easier among small caps

When there are fewer analysts studying a particular company, the higher chance there is of something being missed and the stock price not reflecting the business’ fair value.

This “inefficient market” can provide golden opportunities for investors who put in the time to research the smaller gems.

“The latest Standard & Poor’s SPIVA Scorecard for active managers to December 2021 show that large-cap active managers, on average, have underperformed their benchmark over the longer term after fees,” read the Ophir memo.

“But small-cap managers have outperformed. Our Australian small-cap Ophir Opportunities Fund, which has the longest track record of any of our funds, has also outperformed.”

In the short term though, just like in 2022, circumstances can hinder picking small-cap winners.

“Competition is always increasing in markets and many other things can influence share prices in the short term other than fundamentals.”

4. There are bargains galore

And the final reason to keep faith in small-cap ASX shares is that a volatile time like now generates some excellent bargains to be purchased.

“Of course, a key part of this value has been the painful compression in valuations across most equity markets, generally most pronounced in small caps.”

The Ophir team crunched the cyclically adjusted price-to-earnings (P/E) ratios of the Australian and US small-cap indices versus the large-cap counterparts. 

It concluded that small-cap shares are heavily discounted at the moment and that, starting from now, an annual return rate in excess of 15% across its funds is not out of the question.

“Small-cap market returns look favourable over the next 5+ years,” read the memo.

“A large part of that confidence stems from investing in an attractively valued and less efficient small-cap market with an investment process that we believe gives us an edge in identifying mispriced companies over the long term.”

Motley Fool contributor Tony Yoo has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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