Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 133

Don’t judge all small companies by the poor index returns

When I reflect on the Australian equities industry over a number of cycles, I believe that the small cap sector is still fundamentally misunderstood in terms of investor outcomes. Small caps are normally seen as either an opportunity for phenomenal growth outcomes – a way to add ‘spice’ to more conservative portfolios – or, as prone to absolute carnage and wealth destruction. It is uncommon for investors to see smalls as part of a sustainable long term strategy, for apparent good reasons.

Small cap index returns disappointing

The small cap index has been basically flat over the last three years, during which time the broader ASX300 has gained over 9% per annum. Looking back further, over the last 10 years (as at 30 September 2015) the Small Ords Accumulation Index has delivered investors close to a zero return. It is no surprise then that investors push back when advisors recommend an allocation to small caps.

What explains this underperformance of the small cap index? This index, by its very nature, is more susceptible to market fluctuations due to the fact it includes less tested and more trends-based stocks, such as newly-listed Initial Public Offers. It is also an index that can change rapidly in composition over time. As the mining boom took hold, for instance, investors saw the small cap miners grow from a small percentage of the index to over 40% at the peak of the boom. Most stocks associated with mining recorded strong capital gains as they were bid up to extreme valuations with demand exceeding supply. Investors were chasing the dream of ongoing capital appreciation. Then, as commodity prices fell, the anticipated profits of these companies largely evaporated, destroying investor wealth.

Similarly, the tech wreck of the early 2000s was driven by hope and an indiscriminate belief that every company would experience ongoing capital appreciation.

How is it possible then that over the same period of time some well-credentialed fund managers have delivered solid investment returns?

Not all small caps are created equally

The first lesson is investors should not tar all small caps with the same brush. The sector should be approached with a disciplined investment philosophy, in line with their large-cap objectives. Smaller does not have to mean lower quality. A bottom-up research process can reveal a number of small companies with attributes that can generate sustainable long term returns – competitive advantage, predictable earnings and sound management – trading at a reasonable price.

Sustainable long term returns are a function of both capital growth and growing dividends over time. Consistent and growing dividends are not typically associated with small cap investing. However, from our perspective, this income is an attractive feature of many higher quality smaller companies and is not something investors should forsake for being active in this space.

Steadfast and Pact Group are excellent examples of companies with these quality long term investment characteristics.

Steadfast is an industry leader in Small to Medium Enterprise insurance broking and underwriting with 750 offices across Australia, New Zealand and Singapore. Its broker business has strong bargaining power with insurers, providing them with a distribution channel which cannot be easily replicated. The broking relationship is sticky with client renewal rates over 90%, underpinning a resilient earnings stream. Its underwriting agencies are complementary to the broker business. Going forward, investors can expect earnings growth to come through further acquisitions of brokers in its network, as well as acquisitions of underwriting agencies.

Pact Group is the largest manufacturer of rigid plastics in Australia and New Zealand, with a small presence in the fast-growing Asian region. The majority of Pact’s customers are manufacturers of well-known household and dairy products, including Unilever and Fonterra. Pact also benefits from a dominant market position in a game where scale has significant benefits in the procurement of raw materials, reducing overheads and maintaining a national network of infrastructure and expertise. The real opportunity for Pact is to continue their successful track record of growing through sensible bolt-on acquisitions. The company has grown this way for many years with 43 completed since 2002.

There are many other quality stocks in this sector of the market, which together in a well-constructed portfolio present investors with the ability to generate sustainable earnings growth in the current low growth environment.

Investors should not be put off by the anaemic returns recorded by the small cap index over the last few years, but focus on what active management can achieve with a disciplined process.

 

Simon Conn is Senior Portfolio Manager at Investors Mutual Ltd. This article contains general financial information only and does not consider an individual’s personal circumstances.

 

RELATED ARTICLES

Why caution is needed in Aussie small companies

Large super funds struggle to match index in Aussie equities

Buy the dips?

banner

Most viewed in recent weeks

Which generation had it toughest?

Each generation believes its economic challenges were uniquely tough - but what does the data say? A closer look reveals a more nuanced, complex story behind the generational hardship debate. 

Maybe it’s time to consider taxing the family home

Australia could unlock smarter investment and greater equity by reforming housing tax concessions. Rethinking exemptions on the family home could benefit most Australians, especially renters and owners of modest homes.

The best way to get rich and retire early

This goes through the different options including shares, property and business ownership and declares a winner, as well as outlining the mindset needed to earn enough to never have to work again.

A perfect storm for housing affordability in Australia

Everyone has a theory as to why housing in Australia is so expensive. There are a lot of different factors at play, from skewed migration patterns to banking trends and housing's status as a national obsession.

Supercharging the ‘4% rule’ to ensure a richer retirement

The creator of the 4% rule for retirement withdrawals, Bill Bengen, has written a new book outlining fresh strategies to outlive your money, including holding fewer stocks in early retirement before increasing allocations.

Simple maths says the AI investment boom ends badly

This AI cycle feels less like a revolution and more like a rerun. Just like fibre in 2000, shale in 2014, and cannabis in 2019, the technology or product is real but the capital cycle will be brutal. Investors beware.

Latest Updates

Weekly Editorial

Welcome to Firstlinks Edition 628

Australian investors have been pouring money into US stocks this year, just as they start to underperform the rest of the world. Is this a sign of things to come? This looks at 50 years of data to see what happens next.

  • 11 September 2025
Exchange traded products

Are LICs licked?

LICs are continuing to struggle with large discounts and frustrated investors are wondering whether it’s worth holding onto them. This explains why the next 6-12 months will be make or break for many LICs.

Retirement

We need a better scheme to help superannuation victims

The Compensation Scheme of Last Resort fails families hit by First Guardian and Shield losses, as well as advisers who are being wrongly blamed for the saga. It’s time for a fair, faster, universal super levy solution.

Investment strategies

5 charts every retiree must see…

Retirement can be daunting for Australians facing financial uncertainty. Understand your goals, longevity challenges, inflation impacts, market risks, and components of retirement income with these crucial charts.

Economy

How bread vs rice moulded history

Does a country's staple crop decide elements of its destiny? The second order effects of being a wheat or rice growing country could explain big differences in culture, societal norms and economic development.

Investment strategies

Small caps are catching fire - for good reason

Small caps just crashed the party like John McClane did in the movie, Die Hard - August delivered explosive gains. With valuations at historic lows, long-term investors could be set for a sequel worth watching.

Defensive growth for an age of deglobalisation, debt and disorder

Today’s new world order appears likely to lead to a lower return, higher risk investment environment. But this asset class looks especially well placed to survive, thrive, and deliver attractive returns to investors.

Economy

Will we choose a four-day working week?

The allure of a four-day week reflects a yearning for more balance in our lives. Yet the reliability of studies touting a lift in productivity is questionable and society may not be ready for such a shift anyway.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.