Since the pre-Covid peak on 20 February 2020, the stock market as measured by the benchmark S&P/ASX 200 has returned 7.5%, including dividends. By comparison, the Small Ordinaries index, which measures the performance of companies ranked 101^st to 300^th by market capitalization, has returned 12.8%.

Stock Market Returns

From the depths of the Covid-19 market meltdown, when the S&P/ASX 200 closed at 4546 on 23 March last year, small caps have returned 75.3% compared to the overall market’s 67.8%.

So why the outperformance? And will it continue into 2022?

Firstly, it is important to understand the composition of small cap stocks in the Australian share market. In broad terms, they can be comprised into four buckets:

1. Domestically focussed companies that sell to Australian consumers and businesses. These companies benefit when the Australian economy grows. They are the largest group, making up about 40% of small caps;
2. Australian headquartered companies that derive most of their revenue from American or European consumers and businesses. They win when the US and European economies are strong. They make up about 20%;
3. Mining and mining service companies – about 25%; and
4. Biotech/pharma/technology companies – about 15%.

Because economic growth has rebounded strongly since the outbreak of the pandemic, companies focussed on selling to consumers and businesses have done well. Mining companies have also mainly been supported by higher commodity prices, so with three out of the four categories enjoying tailwinds, it is not that surprising that at a high level. small caps have done well.

At an industry level, small cap companies are different to the broader market. The table below shows the respective weightings according to the 11 GICS sectors.

The most notable difference is the high weighting of consumer discretionary companies at 15.0% compared to the broader market’s 4.5%. Information technology, materials (chiefly mining) and real estate are also higher in the small ordinaries index, while financials, health care and consumer staples are below the S&P/ASX 200.

Looking ahead to 2022, with global economic growth expected to be strong as the world recovers from the pandemic and commodity prices prove to be resilient, small caps should continue to perform well. The risks to this scenario would appear to be Omicron (or some other Covid variant that leads to a fourth/fifth wave and ongoing lockdowns), or inflation rearing its ugly head and Central Banks raising interest rates aggressively.

While we won’t know the full extent of the omicron threat for some weeks, there seems to be a clear intent by Governments to “live with Covid” and avoid lockdowns. The inflation risk and associated higher interest rates are probably more real, although most commentators lean to the view that “inflation is transitory” and Central Banks are still being extraordinarily accommodative in regard to monetary policy.

If you want to invest in small caps, here are four ways to do it. Obviously, you can buy individual companies, but it is hard (but not impossible) to develop a diversified portfolio. But within a ‘core and satellite’ approach where the core is represented by the big ‘blue chips’ and other market leaders, and the satellites are small caps, this could prove to be a smart play. You still have to know which small cap stocks to buy.

Using a fund manager is probably the easiest way. The lowest cost and simplest is an index tracking ETF (exchange traded fund). ISO from iShares, SSO from Statestreet and SMLL from Betashares each track the Small Ordinaries Index, while Vanguard’s VSO tracks the MSCI Australian Small Companies Index and VanEck’s MSV tracks the MVIS Australian Small Cap Dividend Payers index.

Listed investment companies that specialise in small caps include WAM Microcap (WMI), Mirabooka Investments (MIR) and Naos Emerging Opportunities (NCC). Because these companies have finite capital, they can trade on the ASX at a material premium or discount to their underlying NTA (net tangible asset value).

A third way is through an actively managed fund, such as the Firetrail Australian Small Companies Fund. These are typically available through mFunds or via the major investment platforms.