Want to make big returns? ASX small-cap shares are poised to outperform

Smaller businesses could be compelling investments today, according to an expert.

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ASX small-cap shares have been battered and bruised over the last few years, but now might be the time to look at those businesses with smaller market capitalisations.

The broker Wilsons recently pointed out that ASX small-cap shares typically underperformed large caps in the lead-up to an economic slowdown, and this cycle had been "no exception", with small-cap ASX shares underperforming "significantly" since 2021.

However, Wilsons said the growing economic data of resilience, combined with easing inflation pressures, could "provide the foundations for a strong comeback in small cap benchmarks in 2024 and 2025 as global and domestic economic growth picks up again."

Here's why the broker thinks investors should like (ASX) small-cap shares.

Cheaper valuations

Wilsons said small-caps were still trading at a "very wide and historically attractive discount relative" to large-cap stocks. Global small caps were supposedly trading at the "largest discount relative to large caps in over 20 years".

In previous periods, when small caps have traded at large discounts, they have gone on to deliver strong returns over the next 12 months, particularly when economic conditions and the official policy backdrop turn supportive.

Economies to rebound?

Wilsons suggested (ASX) small-cap shares outperformed large caps in the early, or expansionary, stages of the economic cycle as growth picks up again.

The broker pointed to 2009 and 2020 as the last two times small caps were cheap, which then saw strong performance for the smaller businesses.

Interest rate cuts

What happens with interest rates can also have an essential influence on performance at the smaller end of the market.

Wilsons said small caps have historically outperformed large caps in the year after an interest rate peak as policy is eased.

On this topic, Wilsons wrote:

We are cognizant of the risk of the lagged impact of tighter monetary policy as well as the higher-for-longer rate scenario. However, in our view, there are encouraging signs of a soft-landing scenario for both the US and global economy. The Australian economy also appears on track for a soft landing in 2024 followed by a growth pick up next year in response to lower policy rates.

While it may not be a perfectly smooth ride, with valuations looking compelling, and the prospect of easier monetary policy encouraging a pick-up in growth over the next 12 to 18 months, we expect the small company asset class to perform well over the coming year and most likely beyond.

My thoughts on ASX small-cap shares

I agree with Wilsons, there are a number of attractive opportunities to be found on the ASX. I'm personally looking closely at names like Airtasker Ltd (ASX: ART) and Close The Loop Ltd (ASX: CLG) which are growing revenue, improving margins and have appealing growth potential.

Some small-cap names have already soared in the last few months, with a few taken over by buyers.

I think quality smaller companies are capable of outperforming bigger businesses over the long term because their growth runways are longer.

Motley Fool contributor Tristan Harrison has positions in Close The Loop. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended Close The Loop. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has recommended Airtasker. The Motley Fool Australia has recommended Close The Loop. 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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