Small-cap ASX shares have, on average, lagged their larger competitors over the past few years.
And smaller ASX stocks haven't gotten any help from the rapid increase in interest rates since the RBA began its tightening cycle in May 2022.
On 3 May 2022, the official cash rate stood at a rock bottom 0.10%. On 4 May 2022 that was raised to 0.35% in what would be the first of 10 consecutive monthly interest rate hikes from the RBA.
Since 6 May 2022, the S&P/ASX 200 Index (ASX: XJO) has gained 3.7% (excluding dividends).
As for small-cap ASX shares, the S&P/ASX Small Ordinaries Index (ASX: XSO), which holds 200 companies but excludes the biggest 100 from the ASX 200, has lost 8.3%.
That's not to say some smaller stocks haven't delivered outsized returns.
Most of the roughly 2,200 companies listed on the ASX are small-cap ASX shares, after all.
But with interest rates in Australia and most of the developed world looking set to come down in 2024, The Motley Fool asked Andy Gracey, portfolio manager of the Emerging Companies and the Australian Shares Fund at Australian Ethical Investment, whether 2024 might be the time for small-cap ASX shares to regain their shine.
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Will 2024 see a rebound for small-cap ASX shares?
"We are encouraged with the outlook for domestic inflation and interest rates," Gracey told us.
"The market now expects the RBA to cut interest rates in the second half of 2024 and into 2025. This change in sentiment drove the share-market rally in late 2023."
With lower rates on the horizon, Gracey said the appeal of risk assets like property and shares will be more attractive to investors going forward.
"The initial share-market beneficiaries have been large-cap or ASX 100 companies, with small companies also performing strongly in the December quarter," he said.
And there could be some outperformance ahead for small-cap ASX shares in 2024.
"Small companies and particularly microcap companies have underperformed their Australia blue-chip peers over the last few years, so there certainly is rationale to anticipate some form of catchup for these emerging companies," he told us.
But Gracey cautioned that inflation may prove stickier than many investors are hoping.
"We do, however, expect inflation to be persistent and don't expect interest rates to retrace to the levels seen earlier this decade," he said, pointing out there's still a fair way to go before inflation comes back down to the RBA's 2% to 3% target range.
"There are also challenges around company valuations," he added of investing in small-cap ASX shares, noting the 25% price to earnings premium for the small companies' index compared to the ASX 200.
According to Gracey:
Once you go outside the ASX materials and financials sectors it's a real struggle to find compelling value, especially in the context of a risk free 10-year Australian government bond yield sitting at 4.3%
Another challenge for all companies and particularly small companies is that the RBA lowering interest rates is typically accompanied by a weakening economy and depressed company earning.
With these thoughts in mind, we asked Gracey about the pros and cons of investing in small-cap ASX shares versus blue-chips.
Benefits and risks of investing in the smaller end of the market
"The rationale for investing in ASX small caps versus blue-chips is superior capital growth over the long term," he said.
"Small companies are more focused and specialised on their core markets and offer superior revenue and profit growth versus blue-chips."
Another potential benefit of buying small-cap ASX shares, he said, was that these "are also more likely to be targets for private equity and strategic buyers".
On the risk side of the ledger, Gracey cautioned that "these companies do have more volatile trading updates and share prices".
He added:
This is because small companies are typically more vulnerable to macro, regulatory and industry challenges as they have fewer levers or tools to manage through these disturbances.
We have also seen the stock trading liquidity challenges in small and particularly microcap companies over recent periods as investors departed this section of the market.
