Small-cap ASX shares have really been on the nose in the past year as valuations have plummeted in the face of raging inflation and the fear of an economic slowdown.
And with much of the world facing financial troubles in 2023, many experts are still advising investors to stay away in favour of defensive value stocks.
But Forager Funds chief investment officer Steve Johnson, in a report to clients, reckoned that small caps could see a massive turnaround this year.
"That might seem counterintuitive. Everyone is telling you to buy defensive, resilient businesses, right?
"Well, in and of itself, what everyone is telling you is often a good contrarian indicator. But global small-cap fund manager Global Alpha recently released research suggesting there is more to my question than a simple contrarian viewpoint."
'Undemanding valuations' combined with recession resilience
For Johnson, three positives make small-cap ASX shares a tempting choice at the moment.
Firstly, small-cap stocks are starting 2023 from a very low base.
"The S&P/ASX Small Ordinaries (ASX: XSO) was down 21% for 2022, versus an All Ordinaries (ASX: XAO) that was down just 7%. For non-mining companies, the performance was even worse," said Johnson.
"That leaves us with some undemanding valuations. And starting prices matter more than anything else."
Secondly, Johnson argues against the stereotype that large companies are better placed to withstand economic downturns.
"Small companies tend to perform better in a recession than most investors anticipate," he said.
"They can be nimble and agile and are often run by a founder or significant shareholder who has a strong incentive to make tough decisions early."
Thirdly, acquisitions are "far more attractively priced" in periods of economic slowdowns, and smaller companies are much more likely to be involved.
"That is both for companies that are doing the acquiring and those that get bought," said Johnson.
"Our Forager Australian Shares Fund received takeover offers for five different companies in the second half of 2022, out of a portfolio of just 30 stocks."
It's this combination of low expectations built into the share prices and businesses performing through recessions that make small caps compelling at the moment.
And historically, judging from the Global Alpha research, small caps have outperformed large caps for years after the economic troubles have passed.
"In the US, small caps were the best-performing asset class for the five years post the 1973/4 market meltdown, through a recession and a decade of high inflation," said Johnson.
"My grandmother always tells me the secret to happiness is low expectations, though. The good news is that expectations are a lot lower today than they were just 12 months ago."
