Michael Steele, Co-Head of Small Cap Equities

Cyclical small companies may be among those most likely to outperform in an anticipated small cap recovery from the doldrums of the past few years.

Local small caps as a whole struggled last year as higher interest rates and slowing economic activity depressed demand for their goods and services, while simultaneously increasing their debt burden.

In fact, the S&P/ASX Small Ordinaries Accumulation Index has underperformed the top 100 companies by 30 per cent over the past three years as investors have instead focused on the stellar gains in the US sharemarket and a small number of growth companies more generally.

That trend is now expected to reverse and there’s more to this recovery than just an anticipated reversion to the mean. Earnings growth from small companies could be around 10 per cent per annum over the next two years, compared to an average of just 2-3 per cent for the top 100 ASX stocks.

Cyclical small caps are primed to be among the standouts. The multiple rate cuts expected in Australia – potentially beginning as soon as February – will finally support a recovery in their customer demand and obviously reduce the cost of servicing debt.

To put the potential of this cohort into perspective: a tidy 8.5 per cent gain in the overall Small Ords in 2024 was driven by just the top 10 stocks in the index, only one of which was a cyclical company.

The top 10 included family tracking app Live360, Telix Pharmaceuticals and buy now, pay later provider Zip Co. The sole cyclical in the list was CSR – and its momentum was partly attributable to its $4.3 billion takeover by French building products giant Saint-Cobain.

Cyclical stocks best-placed to benefit from a more robust economic environment include companies that can increase earnings from more than just the economic cycle.

Management initiatives that boost market share or reduce operating costs, for instance, will play an equally critical role in their recovering fortunes.

Examples of companies in this category include construction materials and equipment services business Maas Group (ASX: MGH), steel distributor Vulcan Steel (ASX: VSL) and outdoor advertising company oOh! Media (ASX: OML). All are cyclical businesses with strong management teams and the potential for market share gains and margin expansion.

But it’s the resources arena that we believe may deliver some of the best small cap performers of the year. A combination of the cyclical drivers above and structural tailwinds unique to the resources sector provide a solid foundation for potential gains.

Small resource companies have suffered over several years due to concerns about the prospects of economic growth in China. Their share price gains have been further stymied by the markets’ short-term focus on lower-than-expected stimulus measures from the Chinese government and the prospect of tariffs being imposed by the new Trump administration.

Both the latter factors are likely overstated. The reality is that some of China’s stimulus measures are already bearing fruit, and the Chinese government has sent strong signals that it would enact more measures if required to reignite the country’s economy.

In terms of China’s export trade, the potential blow of any tariffs implemented by the Trump administration would be softened by the fact that only 15 per cent of its exports are to the US. Tariffs on that market would not impact its exports to other major trading partners such as Europe, Japan and South Korea.

Beyond geopolitics, the long-term growth in demand for commodities required for decarbonisation is not reflected in the current valuation of small cap resource stocks.

Copper, in particular, is a commodity that will experience increased demand as the push towards net zero economies gathers pace.

The volume of copper per electric vehicle, for example, is up to four times more than required for an internal combustion engine car. It is also an essential component of both electrical transmission capacity and renewable energy infrastructure.

The wide range of applications for copper across different elements of the decarbonisation process, as well as the broader economy, mean this demand is unlikely to be impacted greatly by any uncertainty generated by the Trump administration’s climate policies.

In fact, conservative forecasts from BHP suggest that copper demand will increase by 70 per cent by 2050 – but supply is highly constrained and new copper mines face significant hurdles to establish.

Companies such as Capstone Copper (ASX: CSC) may be well-placed to capitalise on the anticipated increased demand. The dual-listed company – which sits on the Australian and Canadian bourses – has diversified operations across the US, Mexico and South America. Its production volume is likely to increase by up to 100 per cent over the next five years and its costs are expected to fall as those volumes increase and new mines are brought online.

And it’s not just resource companies themselves that could benefit from the above dynamics. Mining service companies will also be at an advantage if higher copper and gold prices lead to a cyclical recovery in exploration activity. Mining tech company Imdex (ASX: IMD) is one leading example in this category.