How this 'rare window of opportunity' is opening for ASX small-cap shares

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ASX small-cap shares offer the potential for outsized rewards. Though those bigger potential gains come along with bigger downside risks along with higher volatility.

There’s no set definition to divide small-caps from large-cap companies.

But ASX small-cap shares are generally defined as companies with market caps of at least $100 million dollars up to around $1 billion.

And while some have shot the lights out and delivered double digit gains over the past year, the ASX small-cap space as a whole has followed a similar pattern we see in the United States, trailing the performance of their larger peers. (Though to a lesser extent in Australia than in the US.)

Below, Andrew Mitchell and Steven Ng, senior portfolio managers at Ophir, detail why global stock markets may be at the verge of witnessing a long-awaited small-cap revival.

What could set ASX small-cap shares alight?

In Ophir’s 17 April letter to investors, Ng and Mitchell noted that in US markets:

2023 was all about large cap growth style companies leading the way, particularly the mega cap tech ‘Magnificent 7. Meanwhile, small caps and value were definitely laggards.

They note that with 2024 tracking largely the same so far, “small-caps are now extremely attractive relative to large and mid-cap companies”.

With “relative valuations at multi-decade lows for small-caps” the fund managers says this is “one big reason to be bullish over the next five to 10 years”.

As for what could set international and ASX-small cap shares on alight, they said, “The standout and most simple catalyst we believe is simply lower interest rates. And, more specifically, ‘soft landing’ rate cuts.”

According to Ophir:

The closer we get to the expectation of soft-landing rate cuts becoming a reality (currently forecast by the market in Q3 this year), the closer we may be to small-caps having a key catalyst for outperformance.

What if there is a recession?

Should the hoped for soft landing for the US economy turn into a hard one, international and ASX small-cap shares are still well-placed to outperform, according to Ophir.

“The good news is that this scenario [a US recession] is largely priced into small-caps versus large-caps, which will limit small-cap relative downside if the US economy turns south,” the fund managers note.

According to Ophir:

Outside of Australia, in every major region small-caps have already underperformed more than in any previous recession. And in the case of Australia the current -17.5% underperformance is just shy of its historical maximum of -20%.

So if a recession was to occur in the US this cycle, the fund managers point out, small-caps across the world have generally already underperformed large caps by more than they have historically in any recession, with ASX small-cap shares very close to their historical underperformance in a recession.

That means the smaller end of the market could even outperform should a recession happen.

And in the wake of that recession, Ophir notes that “in every major region, including Australia, small-caps on average have outperformed large caps in the first year” after a recession.

Putting it all together, Mitchell and Ng conclude:

It becomes clear that small-cap stocks are a very attractive proposition relative to large-caps, which is giving investors a rare window of opportunity now to buy into small-caps.

If you’re interested in investing in this “rare window of opportunity”, but unsure of which ASX small-cap shares to buy, make sure to get some expert advice.

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Motley Fool contributor Bernd Struben has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.