ASX small-cap shares are off to a good start in the new year and are rising faster than the major indexes.
The S&P/ASX Small Ordinaries Index (ASX: XSO) has risen by 1.54% in 2025 so far.
This compares to a 1.33% increase for the benchmark S&P/ASX 200 Index (ASX: XJO) and a 1.09% rise for the S&P/ASX All Ordinaries Index (ASX: XAO).
The Small Ords Index tracks the performance of companies ranked 101 to 300 by market capitalisation in the S&P/ASX 300 Index (ASX: XKO).
Wilson Asset Management lead portfolio manager Oscar Oberg says it's a good time to buy ASX small-caps due to an imminent tailwind for them in Australia that is already playing out in overseas markets.
What's the imminent tailwind for ASX small-cap shares?
It's interest rate cuts.
Put simply, interest rate cuts lower the cost of doing business for young companies carrying major debt or applying for new debt.
Young companies — or ASX small-cap shares in the case of listed young companies — need debt to stay operational until they achieve profitability, which can take years.
Just a single rate cut can mean a major reduction in costs on very high levels of debt.
This is incredibly helpful for young businesses, especially at a time when they are also dealing with higher input costs due to inflation.
Falling interest rates tend to inspire more investment in ASX small-cap shares which, by nature, have more room for share price growth than larger, established companies.
This historical trend has already begun to play out in the United States since the Federal Reserve began cutting interest rates in September.
In a recent blog, Oberg said:
The strong performance of small cap companies in the US following a rate cut illustrates how an expected rate cut the first half of 2025 can be a tailwind for Australian small caps.
When will the RBA cut interest rates?
Most economists expect the first rate cut to be next month or in May.
As we recently reported, chief economist at Westpac Banking Corp (ASX: WBC), Luci Ellis, is tipping May.
She said:
An interest rate cut in February or April cannot be entirely ruled out; but on balance, May remains the most likely candidate for the start of the normalisation cycle.
As reported in the Australian Financial Review (AFR), many chief investment officers at Australia's superannuation funds expect a cut in May or July.
What will happen to ASX small-caps after the RBA cuts rates?
Oberg said ASX small-cap shares have underperformed ASX large-cap shares by 8% over the past four years, commenting:
It's been a challenging period for small cap companies.
Despite delivering a positive return of 16% in Australia, in the past four years to November 2024, their total return (income and capital growth) underperformed large caps by 8% pa in Australia, 6% pa globally and 5% pa in the US.
Does this underperformance suggest small caps are now undervalued, especially given company earnings have also declined? Yes, this is evident in the US and Australia.
Oberg said the EV/EBITDA multiple of ASX small-cap shares (defined as the S&P/ASX Small Ords Index) relative to large caps (defined as the S&P/ASX 100 Index (ASX: XTO)) is tracking at a 24% premium.
This is well below the 20-year average of a 32% premium.
He said:
A reversion back to historical average multiples would result in small cap share price outperformance.
Oberg said the Wilson Asset Management team has a positive view of ASX small-cap shares this year.
We think a number of sectors within small caps that have struggled in a period of rising interest rates and cost of living pressures, such as retail, automotive, real estate investment trusts, building materials and media, will see an uplift in earnings and consequently share prices as interest rates decline.
Consensus earnings per share (EPS) growth in 2025 is forecasted to be 34% in the S&P/ASX Small Ordinaries Index compared to just 3% in the S&P/ASX 100.
This means that even in an environment where valuation multiples, such as price to earnings, do not change, share prices should increase as earnings grow.
