Please enjoy this Q&A with Oscar Oberg, Lead Portfolio Manager WAM Capital, WAM Microcap, WAM Research and WAM Active.
Wilson Asset Management is a pro bono fund managers for Future Generation Australia (ASX: FGX)
Future Generation Australia has a strong bias towards small, mid and micro-cap companies, although it’s been a challenging period for the sector. The total return of small-cap companies have lagged their large-cap counterparts, the S&P/ASX 100, S&P 500, and MSCI World Index by 43%, 55% and 38% respectively over the four years to November. Does this mean small caps are due their time in the sun?
Yes, we think small-cap companies will have a strong period as we look forward into 2025. With the Reserve Bank recently signalling that inflation is beginning to ease in Australia, we think a number of interest rate sensitive sectors in the small-cap sector – such as retail, automotive, real estate investment trusts, building materials and media, which have struggled in a period of rising interest rates and cost of living pressures – can actually outperform as interest rate expectations are cut.
What’s causing this underperformance of small-caps compared to large-caps?
There are several factors at play here.
- Higher interest rates: Small-cap companies often have higher levels of leverage, which makes them more sensitive to rising rates. Also, a large proportion of the Australian market in small-caps – some 35% – are in sectors such as retail, automotive, real estate investment trusts, building materials and media, which are highly sensitive to changes in consumer sentiment and discretionary expenditure. These sectors have been weak since interest rate expectations began to rise from late 2021.
- Inflation: Smaller companies typically have less dominant market positions, lower profit margins, and less pricing power to pass on higher costs compared to larger companies.
- Liquidity: Small-cap stocks are less liquid, meaning it’s harder for institutional investors to buy or sell large amounts of shares without affecting the price. In times of macroeconomic uncertainty, this liquidity issue often drives investors towards larger, more liquid companies.
- Capital raising difficulties: Higher interest rates mean it’s more expensive for companies to raise debt or equity and this has an outsized impact on smaller companies that need to raise capital for growth. So far in 2024, Initial Public Offerings (IPOs) on the ASX have totalled just $581 million, a 15% decline on 2023 and the lowest year-to-date volume since 2012.
- The rise of ETFs: Passive investing, particularly through Exchange-Traded Funds (ETFs), has created momentum for large-cap stocks, as ETFs often favour the most liquid and widely held stocks, which tend to be large-cap names.
Given the sensitivity of small-cap companies to interest rates, what are you expecting from the Reserve Bank of Australia in 2025, after the Reserve Bank held rates this week?
We think the private sector in Australia is currently in recession with the 0.3% GDP growth achieved in the September quarter, propped up by record levels of government spending. The recent commentary from the Reserve Bank suggests that inflation is beginning to ease and, certainly when we speak to companies, the outlook is getting tougher. We think the Reserve Bank will cut rates by March and we will see three rate cuts in 2025.
Is there any evidence that suggests small caps might rebound soon?
In the past, small-cap stocks have delivered strong returns after periods of rate cuts. As an example since the Federal Reserve began cutting rates in September 2024, small-caps in the US have generated a total return of 10%, outperforming large-caps by 3%. In New Zealand, where the central bank has cut interest rates by 125 basis points, economically exposed small-cap companies owned in WAM Capital have been a large contributor to performance since that cut.
So, what should investors do right now?
For investors, now could be an ideal time to consider small-cap stocks. They are currently undervalued compared to the broader market, and history suggests that after periods of underperformance, small caps tend to experience a strong recovery. While small caps come with risks—particularly in volatile macroeconomic environments—the potential for high returns from earnings growth, improving liquidity, and narrowing valuation gaps makes them an attractive investment opportunity. Active management remains crucial in navigating these opportunities and, at Wilson Asset Management, we are focused on identifying undervalued small caps that can outperform as conditions improve.
Finally, you’re one of the Future Generation Australia’s pro bono fund managers and we’re incredibly grateful for your generosity. Why did you agree to do this?
Geoff Wilson AO, our Founder, has always been a big believer in “making a difference” and this is ingrained within the Wilson Asset Management culture. At Wilson Asset Management, every staff member donates $10,000 every year to a nominated charity of their choice. You will not get a better example of “making a difference” than Future Generation and it is fantastic to see the benefits of the donations to the charities first-hand. It is always a great reminder when managing money how much you can make a difference to these people – and that is certainly something that drives me and the team every day.