Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 381

Why caution is needed in Aussie small companies

Small capitalised companies have had a great run since the market bottomed in late March. The S&P/ASX Small Ordinaries Index is up 60% since 24 March 2020, but by contrast, the larger capitalised companies as represented by the S&P/ASX100 index are only up 26.2% (as at 6 October 2020).

The significant outperformance of smaller companies has ignited renewed interest in this sector of the market. Figure 1 shows the two indexes since December 2019.

Figure 1. A wild ride in equities and even wilder ride in smaller companies

Greater returns but with more volatility

Over the last 20 years, smaller companies have outperformed larger companies by almost 0.86% per annum but this outperformance has not been without risk. On average, the volatility associated with small companies is 17% compared to larger companies with 13%.

This is also evident in the beta (a measure of volatility in terms of the overall market, which has a beta of 1 or 100%) of the small company index averaging 114%, as shown below.

Figure 2. Longer term return and risk characteristics from Australian small and large companies

Smaller companies have had a great run in the last six months but a look at the long term puts that outperformance into some context.

Figure 3 illustrates the journey for the last 20 years. Smaller companies have had periods of significant outperformance, which are historically followed by periods of underperformance. Depending on when you invest, your experience could be quite varied.

Figure 3. Periods of outperformance have historically been followed by periods of underperformance

Valuations are rich in absolute and relative terms

On average, over a longer period of time, we find the smaller capitalised companies tend to trade at a slightly higher price to earnings (P/E) multiple and generate slightly lower yields. But this tends to be volatile, as during risk-on periods they can trade at much higher multiples, whereas during risk-off periods, they can trade at below average multiples.

It is entirely possible that the economy will recover and many company earnings will return to pre-pandemic levels, but if they don't, then the small company sector of the market is more at risk of disappointment. From a relative yield perspective, the smaller companies are not as expensive as is implied by earnings multiples.

Figure 4. Smaller company valuations

Watch out for overly optimistic earnings

For smaller companies compared with larger companies, the investment community is usually overly optimistic on earnings. In the last 20 years expected growth for the next 12 months has averaged +21.1% and yet on average this group of companies has only delivered +13.2%. By contrast, the expected growth for larger companies is expected to be lower at only +9.4% and has only delivered +6.8%. It's a much smaller earnings disappointment compared to smaller companies. In both cases, analysts’ expectations have been overly optimistic but in the case of smaller companies, this optimism is exaggerated.

As investment managers that focus on quality, value, improving outlook and lower volatility, we tend to invest in less volatile companies that have not been priced for excessive growth. That does not mean we will not invest in smaller companies if they are expected to provide the right mix of return for risk.

Indeed, as Figure 5 below highlights, we currently own many companies outside the top 50 but within the top 200, but our active weight in these companies changes.

Figure 5. State Street Australian Equity Fund – Active weight to different sized companies since inception^

 

Currently, valuations are stretched for the market and are especially stretched to the smaller end of the index. Most of this has happened in the last six months as investors have been willing to price a strong recovery in earnings.

 

Bruce Apted is the Head of Portfolio Management – Australia Active Quantitative Equities, at State Street Global Advisors. This general information has been prepared without taking into account your individual objectives, financial situation or needs and you should consider whether it is appropriate for you. 

 

RELATED ARTICLES

Has passive investing killed small caps?

Australian shares struggle as 2020s reach halfway point

Thinking small to win big

banner

Most viewed in recent weeks

Raising the GST to 15%

Treasurer Jim Chalmers aims to tackle tax reform but faces challenges. Previous reviews struggled due to political sensitivities, highlighting the need for comprehensive and politically feasible change.

7 examples of how the new super tax will be calculated

You've no doubt heard about Division 296. These case studies show what people at various levels above the $3 million threshold might need to pay the ATO, with examples ranging from under $500 to more than $35,000.

Are franking credits hurting Australia’s economy?

Business investment and per capita GDP have languished over the past decade and the Labor Government is conducting inquiries to find out why. Franking credits should be part of the debate about our stalling economy.

Here's what should replace the $3 million super tax

With Div. 296 looming, is there a smarter way to tax superannuation? This proposes a fairer, income-linked alternative that respects compounding, ensures predictability, and avoids taxing unrealised capital gains. 

The rubbery numbers behind super tax concessions

In selling the super tax, Labor has repeated Treasury claims of there being $50 billion in super tax concessions annually, mostly flowing to high-income earners. This figure is vastly overstated.

9 winning investment strategies

There are many ways to invest in stocks, but some strategies are more effective than others. Here are nine tried and tested investment approaches - choosing one of these can improve your chances of reaching your financial goals.

Latest Updates

Taxation

100 Aussies: seven charts on who earns, pays, and owns

The Labor government is talking up tax reform to lift Australia’s ailing economic growth. Before any changes are made, it’s important to know who pays tax, who owns assets, and how much people have in their super for retirement.

7 key charts on the state of the Australian property market

The Australian property market stirs fierce debate - often bullish optimism versus crash predictions. But beyond the noise, seven charts reveal what's really driving prices and the outlook for residential real estate.

A simple alternative to the $3 million super tax

Division 296 aims to introduce improved fairness into the superannuation system, yet is overly complex. This scours the world for better ideas and suggests a simpler alternative which can achieve the same goals.

CBA and the index conundrum for super funds

After the hyperbolic rise in CBA shares, super funds are floating the idea of carving out the weightings of ASX bank securities and indexing them within their portfolios. This looks at why that might be a big error.

Strategy

10 policies to drive Australian productivity higher

Here's a comprehensive list of proposed reforms to fix Australia's stagnating economy, including introducing a flat income tax rate, reducing migration, and making childcare tax-deductible.

Interviews

Where to find big winners in Asia

As more money looks for a home outside the US, Asia may soon get some love. Fidelity's Anthony Srom outlines the best places in Asia to invest, including in Chinese consumer names, Indian financials, and Thailand.

Investment strategies

We have trouble understanding the time value of money

We overvalue the present and underestimate the future - it’s a cognitive glitch called hyperbolic discounting. It affects savings, spending, and loans, and it's more common - and costly - than we think. 

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.