2024 may well be the year we see small-cap ASX stocks make up some lost ground and outperform their larger peers.
Some smaller ASX shares have certainly delivered outsized gains over the past few years. But overall ASX small-cap stocks have underperformed the big blue-chip companies, with the S&P/ASX Small Ordinaries Index (ASX: XSO) trailing the returns delivered by the S&P/ASX 200 Index (ASX: XJO) over two years.
According to Andy Gracey, portfolio manager of the Emerging Companies and the Australian Shares Fund at Australian Ethical Investment:
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.
With that potential catchup in mind, The Motley Fool asked Gracey what investors should consider before buying into the smaller end of the market.
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What to investigate before buying small-cap ASX stocks
Gracey said there are "a multitude of factors we, as investors, like to see in the small companies we are investing into".
First, he said, "We like to see an objectively calculated and decent sized total addressable market."
He said his preference with small-cap ASX stocks is towards a global focused business, and one with "barriers to entry such as intellectual property".
Second, Gracey recommends steering clear of companies whose business models you can't easily comprehend.
"We must be able to understand the business model easily, as complexity brings problems," he told us.
Third, keep an eye on that M&A potential.
"We like to invest in industries where mergers and acquisition occur regularly," he said.
The fourth thing to research before buying a small-cap ASX share is its ongoing revenue outlook.
"We prefer higher gross profit margin businesses, and recurring revenue streams, whether this is subscription revenue, consumable revenues or recurring transactional," Gracey said.
And the fifth factor is seeing some reputable skin in the game.
"We really like to invest alongside executive management and the board, and we look for recognisable and trustworthy names on the board," he said.
Why invest in ethical small-cap companies?
While we were on the subject of investing in the smaller end of the market, we asked Gracey why his fund is particularly focused on ethical small-cap ASX stocks.
According to Gracey:
We believe combining a rigorous ethical screen with an active investment management approach can be a rewarding investment experience. Our equity funds are typically overweight forward-looking industries such as renewables, healthcare and technology.
We are overweight in industrial companies and small companies, while being underweight in the cyclical materials and energy sectors.
But can ethical small-cap ASX stocks match the returns of those that fall outside this category?
"We believe investors don't have to sacrifice investment returns while investing in more progressive companies that leave the world in a better place," Gracey said.
