Australian investors have shown an interest in ASX small-cap shares in recent weeks amid a sharp correction in the broader markets.
As we entered the new financial year, the S&P/ASX Small Ordinaries Index (ASX: XSO) rallied 4.6% to a high of 3,087 points on 17 July.
Meanwhile, the large-cap S&P/ASX 200 Index (ASX: XJO) was up just over 4% and nudged an all-time high of over 8,000 points a day later.
Many are concerned about a supposed rotation out of large-cap shares into the smaller end of the market as a potential sign the market might be slowing. This may or may not be true – both indexes for large-cap and small-cap shares are down around 2% in the past week.
Let's take a closer look.
Time to consider ASX small-cap shares?
Some fund managers believe that potential interest rate cuts could drive growth in small caps. With speculation the US Federal Reserve might start cutting interest rates as early as September, investors are already repositioning portfolios.
Fidelity Australia's Lukasz de Pourbaix notes that market confidence is shifting away from mega-caps towards shares with smaller market caps. This is driven by the anticipation of controlled inflation and rate cuts. According to The Australian Financial Review, the specialist said:
The market has got a little bit more confidence that we may see rate cuts and that the inflation journey in the US is under control.
So we're seeing the market rotating out of those mega caps, which are considered the safer parts of the market, as it now has a bit more confidence to go down the market cap spectrum.
While the trend is observable globally, ASX small-cap shares have lagged behind their large-cap counterparts in recent weeks.
But that hasn't deterred many fundies. Firetrail Investments warns investors not to wait too long, stating that small caps tend to recover before the economy hits its trough. Portfolio manager Eleanor Swanson said, per the AFR:
Small caps tend to run six to nine months before we see economy troughs, and we all know that it's pretty tough in Australia, particularly for consumers.
But the minute we get a sign that the RBA is cutting … it's already too late to wade into small-cap equities. You really need to be there before the economy troughs.
Where are the opportunities?
The question is, where to start looking? Hyperion Asset Management has some pointers. It suggests investing in small caps with low debt loads and growth potential might be the way to go – even in "rising rate markets".
If you can identify those really high-quality businesses that are the leaders of the future, and you have a disciplined approach to investing in them, it can be really, really valuable investment.
Meanwhile, Firetrail Investments sees potential in small-cap resource stocks despite their poor performance over the past 12 months. With commodity prices starting to recover, it is "seeing really interesting opportunities" in the space.
ASX small-cap shares with potential
My colleague James recently outlined two ASX small-caps currently in favour by brokers.
Analysts at Bell Potter are bullish on copper miner Aeris Resources Ltd (ASX: AIS). They have a buy rating and price target of 30 cents on the stock.
The broker highlights AIS' strong copper mining exposure and its growth prospects, which are driven by new high-grade ore sources at the Tritton copper mine.
Whereas Morgans analysts see significant growth potential in regenerative medicine company AVITA Medical Inc (ASX: AVH).
The firm rates AVITA a buy with a $5.60 price target. It is attracted to the company's guidance of 64% revenue growth in FY24.
Foolish takeaway
Some fundies believe ASX small-cap shares might be poised for a comeback. As global economic conditions shift, this may or may not be the case.
Small caps can carry outsized volatility and may experience more sensitive fluctuations to overall market movements.
As such, you should always conduct your own due diligence before making any investment decisions.
