Investors are probably sick of hearing about how unsustainably expensive Australian banks are in general and CBA in particular relative to the rest of the market. That CBA trades at a meaningfully higher P/E than Alphabet (Google) (23x vs 19x) is a very different picture to pre COVID when in 2018 CBA was on 13x and Alphabet was on 21x. Active large cap investors probably have many more ways to show how extreme these valuations are, but one story we heard repeatedly from financial advisers in September was “everyone told me CBA was expensive at A$100, and here we are nine months later at A$140 so I am glad I didn’t sell”. Behaviorally this makes investors less likely to sell due to the endowment effect and recency bias, but could make the decision to sell at A$140 even more valid than it was at A$100.

We don’t know. We are not large cap bank investors.

But it prompted us to do some digging into what the most extreme bank valuations many investors have seen in their careers may mean for small caps.

Banks are quintessential large caps. They are businesses that benefit from scale. They are in very well developed, mature, stable and slow-moving industries. They are heavily regulated. Governed and managed by committee. History shows if things go very poorly, the government is there to make sure the downside for equity holders is limited. That is not their explicit intention, but it has been the outcome.

Small caps are in many ways the opposite of banks. Their advantages are often in their smaller size, exposure to newer, less developed industries which are growing quickly. Executing at speed, with an incentivised management team – often founder rather than committee led – tends to correlate more with success that ongoing strategic reviews and input from management consultants. If things go poorly for small caps, shareholders are on their own. In many cases the downside is a total loss of capital.

Over the past four years there are two truths about the Australian market seared into the consciousness of investors: 1) Small caps have underperformed the ASX300, by a lot (-7% p.a) and for a long time and 2) Banks have outperformed the ASX300, by a lot (+14% p.a) and for a long time. These two themes have been so dominant that positioning relative to the benchmark in these two groups would have swamped almost any other investment decision you could make as an ASX300 benchmarked equity investor.

This dominates many investors framing of how to structure their broad Australian equity portfolios as we enter the final quarter of 2024.

We offer a couple of thoughts.

One decision an investor may consider right now is to reduce their exposure to Banks. Given the outperformance, valuation and likely increased percentage of their portfolio, this would be a sensible decision. The second question though is what to invest into? What has historically performed well when banks underperform?

Small Caps.

Since 2005, in five of the six periods when banks underperformed the ASX 300 by more than 5% over 12 months, small caps outperformed the ASX 300 by 10-20% over the same 12-month period. The one exception was mid-2023 when small caps were still in a COVID hangover bear market and bank underperformance was very short lived.

This also goes the other way. When banks are outperforming, five out of six times small caps are underperforming. The one exception was coming out of the GFC when receding credit risk saw both banks and small caps outperform the broader market.

For the numerically minded, the correlation between the 12-month excess returns to the ASX 300 between Banks and Small Caps is -34%. They are not the same at all.

Source: Bloomberg, Longwave Capital. Sep 2024

Linking macro-economic developments to stock price performance is imprecise however we have noted some meaningful changes in the economy which may spark a change of market regime. We suspect this is more positive for small caps, but we don’t profess any specific insight here and may be biased in our interpretation.

Key changes we have seen:

Interest rates are declining. September saw the first rate cut by the Fed, and although the RBA is holding rates for now, inflation is back in their target range and falling. The corporate bond market is already in front of this, with investment grade corporate borrowing costs (4.6%) already more than 1% below their late 2023 peak (5.7%) and below the average levels seen in both F2023 (4.8%) and F2024 (5.2%). Consumers have digested higher borrowing costs and investors saw increased interest expense erode EPS growth and pressure multiples. These headwinds are now abating and may turn into tailwinds as F2025 unfolds.

Source: Bloomberg, Longwave Capital Partners. 30^th Sept 2024

Source: Bloomberg, Longwave Capital Partners. 30^th Sept 2024

Tax cuts effective July 1, 2024: “The implementation of the Stage 3 tax cuts and further declines in inflation are expected to result in real incomes growing strongly in the second half of 2024.” RBA Statement on Monetary Policy, August 2024

Australian household wealth remains strong: “Real household net wealth has increased by 5 per cent over the past year and is 22 per cent higher than prior to the pandemic. The increase in wealth since the pandemic has been driven by strong housing price growth, additional savings by households during the pandemic and equity price increases.” RBA Statement on Monetary Policy, August 2024

China Stimulus: Small resources underperformed small industrials by 14% in the 12 months to Aug 2024 and 25% over the prior two years as the Chinese economy looked decidedly soft. China unleashed aggressive stimulus very shortly after the Fed cut, which in turn has highlighted the potential cyclical upswing in commodity demand and pricing. Supply growth in most commodities other than lithium has been modest.

Liquidity in small caps has returned. Stock turnover has improved off the low levels of 2022 and 2023 and bid-ask spreads have also tightened. Both measures we see at normal levels now.

Source: Bloomberg, Longwave Capital Partners. 30 Sep 2024. Longwave small cap universe includes ASX and NZ listed securities outside of the S&P/ASX100 index with a minimum market cap of A$25m.

Source: Bloomberg, Longwave Capital Partners. 30 Sep 2024. Longwave small cap universe includes ASX and NZ listed securities outside of the S&P/ASX100 index with a minimum market cap of A$25m.

Real interest in small caps is increasing. A less objective measure, but we are hearing more active large cap managers talk about their best ideas being in the small and mid-cap market. We are seeing increased attendances at small cap events.

Small cap investors have been in a bear market for so long, many have forgotten what a bull market looks and feels like. The multi-year (rather than just multi-day) outperformance driven by strong EPS growth and P/E multiples re-rating. A vibrant IPO market. The rewards from investing in dynamic, growing businesses exposed to new technology, new industries and new business models. Double digit returns over many years for investors.