Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 525

Has passive investing killed small caps?

The S&P/ASX Emerging Companies Index has underperformed the S&P/ASX 200 Index by 12% over the last 12 months. What does this say about the future of active investment in small companies?

“Past performance is not always indicative of future performance”

Historical performance can often act as a double-edged sword. While the outperformance of large cap indices has drawn investors en masse, the past is not always indicative of the future. What works today, driven by a confluence of factors—be it economic conditions, regulatory environments, or global events—might not necessarily hold its ground tomorrow.

Strong performances by the major, large cap-focused equities indices have outdone active small cap investors for a number of years and lulled passive investors into the false security that their hands-off approach is not only easier but superior.

Average % price change over last 12 months (to Aug 18, 2023)

Source: Koyfin, H&G Investment Management Limited

Concentration

Passive investing in the index was originally pitched as a simple diversification strategy but thanks to its own success, is now shaping up as a form of concentration risk itself.

Index-tracking investors are placing all their eggs in one large cap ‘basket’ that has no fundamental reason to outperform other portfolios in the long-run and is currently priced with far less margin for error than many alternatives - and with more concentration in a small number of securities.

In theory, the passive index should not outperform in the long run. The differences between the index and the average portfolio performance should be limited to fees and other costs.

Does anyone believe that the committee at Standard & Poor’s that selects stocks based on their ‘free float’ has a special and sustainable edge over other investors?

If not, the conclusion that follows is that these large indexes are outperforming because, in their respective markets, a disproportionate amount of capital has been flowing to the index portfolio only.

Passive index investing has become momentum investing - buying equity in businesses without reference to fundamentals and buying more of a stock at higher prices simply because it has already experienced demand that outstrips supply.

When momentum is working for the investor, it makes markets look simple. But when momentum crashes it can get ugly. If a large percentage of investments in the market concentrate on an index, the entire market becomes vulnerable to systemic shocks.

Two strategies to de-risk from the index are: (1) to weight a pool of investments differently to the index; and/or (2) selectively invest in smaller companies that don’t have material (if any) index weightings.

Buying better

Today we look at the Australian equities market and see the market cap weighted average Price/Earnings (PE) ratio of the top 200 stocks is just under 22x earnings reported for the last 12 months.

Unless investors are willing to accept low returns, these companies need to have growth baked in for investors to justify buying ‘the market’ index rather than sticking to the safety of government bonds.

The current ten-year government bond yield of about 4.3% has been closing in on the ASX 200 Index’s market cap-weighted earnings yield, which is the PE ratio inverted, and equates to 4.6%.

While the S&P data on mainstream equities funds has been disheartening for active investors, the evidence does suggest that investors have found greater success relative to the large indexes when focusing on smaller companies.

This market-cap weighted PE multiple for large caps is currently a 24% premium to the median for micro-to-mid caps of 17.5x (excluding the resources sector). If we look at EV/EBITDA multiples, which take into account the total capital structure, the premium is 32%.

Another way of seeing the current opportunity for small caps relative to large caps is the historical relationship between their valuations. The S&P/ASX Small Ordinaries Index, which consists of the companies ranked between 100 and 300, has historically traded on a PE multiple 12% lower than the S&P/ASX 100 heavyweights, looking back to June 2002.

Before COVID-19 hit in early 2020, smaller stocks were actually trading on a premium PE multiple to the top 100. Today that discount is hovering at 26%.

One thing the historical data shows us is that when these extreme valuation gaps emerge, they are always closed again within several years.

There are a number of reasons why such gaps emerge. Small firms are neglected by analysts and investors, leading to a lack of awareness and information flow. Their shares are generally less liquid, meaning investors do not have the luxury of being able to change their minds and sell stocks on a whim. They can suffer from a lack of resources or poor governance.

Neglect

There are nearly 1,800 ASX listings with market caps below $1 billion - and only ~240 valued above that level. Most of the latter make up the S&P/ASX 200 Index.

Analyst coverage is focused on the larger stocks. Around 340 stocks are covered by at least three analysts. Another 260-odd have at least one analyst setting a price target (often from an obscure firm or with the conflict of receiving fees from the researched company). The majority are left with no formal research, adding another barrier for investors who do not have the time or ability to do the work themselves.

Media coverage follows a similar pattern, with a focus on the big end of town and very little insightful or investigative coverage of smaller listed companies.

Yet the great juxtaposition is that studies have shown less researched stocks deliver greater risk-adjusted returns than stocks receiving greater focus from analysts.

Liquidity and exits

The lack of liquidity may be one explanation of the greater risk-adjusted returns from under researched stocks. It is harder to buy meaningful positions in these companies and once a position has been accumulated a decision to sell could be difficult to execute without driving down the price.

To H&G High Conviction Limited (HCF), illiquidity represents opportunity. As managers of permanent capital, there is no pressure to realise investments at a time that doesn’t suit.

A feature of smaller companies is that they don’t necessarily have to rely on increasing investor interest to convert their operating performance into market value. In time, if investors do not appreciate the value creation, larger corporates and financial buyers (like private equity) will seize the opportunity for themselves.

We have seen this play out time and time again - most recently with Ensurance (ASX:ENA), a small ASX-listed insurance agency. Last month, Ensurance agreed to be acquired by leading insurance broker PSC Insurance for ~$25 million and at a 40% premium to the previous closing share price.

A patient, long-term view is necessary to be able to see an investment through from its purchase to the optimal exit. Our investment approach takes that a step further though - we actively work to solicit such opportunities to maximise value.

Active engagement

HCF has found that rolling up our sleeves and working constructively with shareholders, boards and management teams can help maximise shareholder value. This is possible by sitting on company boards directly, sharing previous business experience, identifying stand-out talent, and helping to deploy capital management strategies and M&A.

Successful investment in small companies requires intensive due diligence and active engagement with companies. At HCF, we believe the recent sell-off means there is considerable value in this segment of the market for diligent, long-term investors.

 

Joseph Constable is the Portfolio Manager of H&G High Conviction Limited (HCF) and an executive director of Hancock & Gore Limited (H&G). H&G is the investment manager of and owns shares in HCF. This article is general information and does not consider the circumstances of any investor.

 

RELATED ARTICLES

Why caution is needed in Aussie small companies

Why the ASX is losing Its best companies

Buy the dips?

banner

Most viewed in recent weeks

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.

Why we should follow Canada and cut migration

An explosion in low-skilled migration to Australia has depressed wages, killed productivity, and cut rental vacancy rates to near decades-lows. It’s time both sides of politics addressed the issue.

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.

Australian house price speculators: What were you thinking?

Australian housing’s 50-year boom was driven by falling rates and rising borrowing power — not rent or yield. With those drivers exhausted, future returns must reconcile with economic fundamentals. Are we ready?

Retirement income expectations hit new highs

Younger Australians think they’ll need $100k a year in retirement - nearly double what current retirees spend. Expectations are rising fast, but are they realistic or just another case of lifestyle inflation?

Welcome to Firstlinks Edition 627 with weekend update

This week, I got the news that my mother has dementia. It came shortly after my father received the same diagnosis. This is a meditation on getting old and my regrets in not getting my parents’ affairs in order sooner.

  • 4 September 2025

Latest Updates

Shares

Why the ASX may be more expensive than the US market

On every valuation metric, the US appears significantly more expensive than Australia. However, American companies are also much more profitable than ours, which means the ASX may be more overvalued than most think.

Economy

No one holds the government to account on spending

Government spending is out of control and there's little sign that Labor will curb it. We need enforceable rules on spending and an empowered budget office to ensure governments act responsibly with taxpayers money.

Retirement

Why a traditional retirement may be pushed back 25 years

The idea of stopping work during your sixties is a man-made concept from another age. In a world where many jobs are knowledge based and can be done from anywhere, it may no longer make much sense at all.

Shares

The quiet winners of AI competition

The tech giants are in a money-throwing contest to secure AI supremacy and may fall short of high investor expectations. The companies supplying this arms race could offer a more attractive way to play AI adoption.

Preparing for aged care

Whether for yourself or a family member, it’s never too early to start thinking about aged care. This looks at the best ways to plan ahead, as well as the changes coming to aged care from November 1 this year.

Infrastructure

Renewable energy investment: gloom or boom?

ESG investing has fallen out of favour with many investors, and Trump's anti-green policies haven't helped. Yet, renewables investment is still surging, which could prove a boon for infrastructure companies.

Investing

The enduring wisdom of John Bogle in five quotes

From buying the whole market to controlling emotions, John Bogle’s legendary advice reminds investors that patience, discipline, and low costs are the keys to investment success in any market environment.

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.