Where markets stand

The past eighteen months have tested Australian small cap equity managers with two starkly different market regimes.

Calendar year 2025 was a standout year for small caps. The S&P/ASX Small Ordinaries (Total Return) Index returned approximately 25%, comfortably outpacing the S&P/ASX 100's roughly 9% return over the same period. This outperformance was driven primarily by the Resources sector, which significantly outperformed Industrials within the index. Several forces converged to produce this result:

• The "Trump Tariff" sell-off gave investors a window to buy quality small caps at a discount;
• electrification, the energy transition and data centre construction fuelled heightened demand for exposed metals;
• gold staged a historic rally; and
• three RBA rate cuts drove consumer and long-duration growth names to elevated valuations.

The year closed on a more cautious note, as fears of persistent inflation prompted investors to reprice rate expectations, putting renewed pressure on consumer and high-growth stocks.

Conditions shifted abruptly as 2026 unfolded. Stickier-than-expected inflation, compounded by the outbreak of war in the Middle East, pushed the RBA to raise rates three times between February and May, taking the cash rate back to 4.35%. At the same time, the AI-driven "SaaSpocalypse" and a sharp unwind in gold prices weighed heavily on small caps. The Small Ordinaries has fallen roughly 12% year to date, a materially steeper decline than the broader market's approximate 3% fall.

Against this volatile backdrop we believe that a quality-oriented approach to small caps coupled with a strong valuation overlay and robust risk control will position investors to manage the ongoing noise in the Australian small cap market for the remainder of 2026.

The haves and have nots of FY2026

Rigorous risk management and a strict focus on valuation remain the key pillars for delivering outperformance through periods of volatility

The last 18 months has been a volatile period with market returns driven by macro-economic gyrations, policy uncertainty and strong thematic narratives. This has translated into very diverse outcomes for active managers. Moreover, it would appear that having been wrong-footed, a number of managers have rotated aggressively and chased the momentum, only to see some sectors that led in 2025 substantially underperform in the June quarter.

Key themes

• Resources and gold. The S&P/ASX Small Resources (Total Return) Index returned approximately 73% in 2025, more than double the return of large resource companies and 7x the performance of small industrials. Gold was a key driver, with a 64% rise in the USD gold price translating into significant earnings growth for smaller gold miners. This momentum ended abruptly in March 2026, and the resource sector has materially retraced.
• Momentum over fundamentals. Stock-level fundamentals were frequently overwhelmed by macro and sector rotation dynamics. Software went from “eating the world” to “un-investable” as fear of vibe coding (AI writing code quickly and cheaply) raised question marks on terminal valuations. The super-cycle narrative in resources extended to contractors and particularly to electrical contractors. Companies that historically have traded on approximately 10x earnings are now pricing elevated earnings on multiples in the mid-20’s. Peak multiples on elevated earnings are rarely a recipe for strong future returns.
• Rate sensitivity. Three RBA rate cuts through 2025 appeared to disproportionately benefit smaller caps relative to large caps, given their higher domestic cyclical exposure. Sticky inflation and three rate rises have erased this benefit. Again, macro uncertainty has seen outsized impact on stock valuations.

Overall, the volatility experienced over this time period and the return outcomes seen across the manager universe reinforces our belief in the merits of disciplined risk management. Constructing portfolios in a thoughtful manner in order to dampen the impact of these unforecastable factors is a sensible way to manage through such volatile periods. Equally, with so much change across so many fronts (geopolitics, trade, technology), discipline on valuation will remain another key pillar in delivering outperformance for investors.

The valuation case

The current risk/reward for quality in the small cap space appears as favourable as it has been in some time

Against this backdrop, the Australian small-cap market may appear materially undervalued on both an absolute and relative basis. The de-rating has been broad and, in our view, largely indiscriminate. Based on available market data, relative valuations between small and large caps may be near levels not observed in approximately 25 years. Large-cap earnings growth is tracking close to zero in FY26, while consensus forecasts suggest small caps could deliver earnings growth of up to 10%.

Where we are finding opportunity

Three areas stand out in the current environment:

1. The first is quality market-linked companies that may have been de-rated on macroeconomic sentiment rather than any deterioration in underlying business performance.
2. The second is property developers, where interest rate sentiment has weighed on valuations but where, in our view, supply and demand fundamentals in Australian residential property may remain broadly supportive — with selected developers appearing to trade at discounts that may not fully reflect the medium-term earnings outlook.
3. The third is quality resources, where the energy transition and critical mineral themes may continue to generate long-term demand. Beyond gold, selective opportunities in lithium and other transition metals may be emerging, though the timing and extent of any recovery is uncertain.

Why quality, why now

The quality factor materially underperformed in 2025 and gave back approximately 5 years of outperformance; it is yet to rebound. This underperformance was the result of a confluence of factors – extended valuations, a changing technology landscape that threatens some business models and the rotation to resources driven by the super-cycle narrative. We do believe that this has provided very attractive entry points for a number of quality companies that have been indiscriminately sold off. In our view, the current risk/reward for quality in the small cap space appears as favourable as it has been in some time.

Risk management critical in portfolio construction

Rigorous bottom-up fundamental research, paired with disciplined factor risk management, may support the consistent pursuit of alpha

The potential opportunity in Australian small caps may be meaningful. Capturing it sustainably, across multiple market cycles, requires more than identifying quality businesses. It requires portfolio construction discipline that manages risk as carefully as it pursues return. We believe that rigorous bottom-up fundamental research, paired with disciplined factor risk management, may support the consistent pursuit of alpha. The goal is not simply to outperform in favourable periods, but to build a portfolio resilient enough to compound through difficult ones. In our view, that is how sustainable long-term returns may be generated and why the current entry point, while uncomfortable, could represent one of the more interesting in recent years.

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Important information

This document has been prepared by Bell Asset Management Limited (BAM) ABN 84 092 278 647, AFSL 231091 and is provided solely for information only purposes. This document does not take into consideration the investment objectives, financial circumstances or needs of any particular recipient – it contains general information only. This document does not take into account a recipient’s investment objectives, particular needs or financial situation. It is general information only and should not be considered as investment advice and should not be relied on as an investment recommendation. Before acting on any information, recipients should consider the appropriateness of it and of the relevant product or strategy having regard to their investment objectives, particular needs and financial situation. In particular, recipients should seek independent financial, legal and taxation advice and read the relevant disclosure document or agreement prior to acquiring a financial product or strategy.

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Source: Bell Asset Management as at 10 July 2026