According to Maple-Brown Abbott, Australian small cap companies are well positioned for any downturn given balance sheets are flush with cash and limited debt, the majority of stocks in the benchmark are profitable, and many companies have cost levers that can be pulled.

Co-Portfolio Manager for Australian Small Companies Phillip Hudak said despite economic uncertainty the starting point for the Australian small cap market appears more attractive given the strength of many smaller companies and the recent underperformance relative to other equity asset classes.

“Timing the turnaround in relative performance, however, is extremely difficult, and underperformance can persist for significant periods of time. It is likely a catalyst is needed in the form of easing financial conditions by central banks, an improvement in global macroeconomic data, a peak in interest rates, and/or an improved earnings outlook for smaller companies.

“The Fund is currently defensively positioned, including those companies with genuine pricing power and strong balance sheets. We continue to look to pivot into quality cyclicals and value cyclicals at opportune times,“ he said.

Mr Hudak said a constant theme coming through in most Australian small cap sectors is wage inflation, with the recent 5.75 per cent minimum wage decision – which applies to approximately 20 per cent of the workforce – yet to feed through.

“Australian wage growth has lagged the rest of the world given our more rigid regime, although recent government policies may facilitate greater power for trade unions and employees going forward. As a result, we are also seeing a surge in expectations for annual wage increases under enterprise bargaining agreements to be greater over the next 12 months.

“Rising wages will have a material impact on sectors such as healthcare and retail, where many companies have high labour components as a percentage of sales and minimal pricing power. When assessing these sectors in particular we have a preference for companies with a variable cost base and pricing power. In healthcare, for example, we prefer IVF providers with greater pricing power versus radiology providers which are constrained by the level of indexation.”

Matt Griffin, Co-Portfolio Manager for Australian Small Companies said AGM trading updates could see mixed results for the retail sector, as employment and consumer spending holds up better than expected, but are offset by cost of living pressures.

“In retail, our research and industry contacts indicate that performance is diverging by category. For example, apparel is fairly weak due to over-stocking and competition, while less discretionary goods such as auto parts are holding up relatively well. With foot traffic to many stores falling materially, the coming year will be a chance for the quality retailers to shine, as differentiation around product range, price points and customer service drives better sales results.

“Travel stocks have all materially de-rated over recent months, down around 30 per cent, on the expectation that cost of living pressures and the end of ‘revenge travel' will most likely see travel spend fall in the next 12 months. Despite travel stocks materially de-rating over recent months, we are relatively positive on the sector for a few reasons. Firstly, leisure travel has proven to be extremely resilient in past downturns – provided people have jobs, they will take leave and travel. Secondly, increased airline capacity and falling airfares will draw more people back to longer haul flights, especially families. And finally, many Asian countries have been slow to recover from COVID lockdowns and this will be a tailwind in 2024.

“Our research suggests that travel has held up well in the first quarter of FY24 and forward bookings are strong, and we may see renewed interest in the sector with trading updates being better than feared,” he said.