Why Small-Cap Funds Rebound Faster After Downturns

Periods of market recovery often create fertile ground for smaller companies. While large-caps tend to lead in stable conditions, small-cap funds have historically shown greater agility during the early stages of economic expansion. Their faster rebounds come from exposure to cyclical sectors, leaner cost structures, and higher sensitivity to improving business confidence.

In Australia, this pattern is resurfacing. Recent strength in small-cap indices points to a shift in sentiment, with the S&P/ASX Small Ordinaries Index showing signs of renewed momentum after several years of underperformance. Investors are beginning to revisit this segment for its combination of growth potential and diversification.

The Small-Cap Recovery Story

Small-cap funds invest in companies outside the top 100 listed on the ASX, capturing the entrepreneurial and innovation-driven segment of the market. These businesses often move through sharper cycles of contraction and expansion, yet they have historically rebounded faster once economic conditions begin to stabilise.

Over the past year, improving economic indicators, stronger earnings outlooks, and easing inflation have renewed optimism across this segment. The August reporting season was described by analysts as the strongest for Australian small-caps in more than 25 years, with positive earnings revisions across consumer discretionary, real estate, and technology sectors.

Analysis from BetaShares, citing S&P/ASX data, shows that Australian small-caps have consistently outperformed large-caps in the months following major downturns, including the 2003, 2009, and 2020 recoveries. Their greater exposure to cyclical sectors and domestic demand provides a natural advantage when confidence returns and liquidity improves.

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Insights: Australian small-caps have historically outperformed large-caps in the first six months following major market downturns, reflecting their higher sensitivity to improving economic conditions.

Factors Behind the Recovery

Economic Momentum

Recent data indicates that household spending in Australia rose 5% over the year to August 2025, and small-business sales growth has rebounded into early 2025. Smaller companies tied to cyclical sectors such as consumer discretionary and real estate are likely to benefit as domestic demand stabilises.

Interest Rate Outlook

Market expectations of interest-rate cuts through 2025 have improved the risk-reward profile for smaller growth-oriented firms. Lower funding costs and easier access to credit typically boost profitability and valuation multiples for small-caps, which rely more heavily on reinvested earnings for expansion.

Valuation Advantage

Australian small-caps continue to trade at a discount relative to large-caps, a valuation gap that has persisted for several years. This divergence has historically narrowed during market recoveries as investor confidence and earnings visibility improve.

In a recent interview with Ausbiz, "Small Caps with Golden Upside: Emanuel Datt on Ausbiz", Emanuel Datt noted that this long-standing gap remains intact, presenting compelling opportunities for investors who can take a two to three year view:

“The valuation gap between small caps and large caps has persisted for years. That gap still exists today, creating very attractive opportunities for long-term investors.”- Emanuel Datt, Ausbiz Interview (2025)

Earnings Growth

After several years of lagging behind larger peers, the tide appears to be turning. The S&P/ASX Small Ordinaries Index has rebounded nearly 25% year to date, significantly outpacing the 8% gain in the ASX 100. 

One driver of this resurgence has been renewed strength in the materials sector, which currently represents around 25% of the index. Within that, gold producers now comprise 17%, well above their historical average of 5–7%, reflecting a sharp increase in investor demand for real assets and inflation hedges.

Insights: Australian small-caps have narrowed the performance gap with large-caps since mid-2022, supported by improving earnings outlooks and renewed investor interest.

Risks and Market Considerations

Even as conditions improve, investors should remain mindful of the inherent volatility of the small-cap universe.

• Recession Timing: Economic forecasting remains uncertain. A delayed or shallower rate-cut cycle could slow recovery for rate-sensitive sectors such as real estate and consumer discretionary.
• Historical Performance: While small-caps tend to outperform in recoveries, they can also experience deeper drawdowns in downturns. Managing exposure and maintaining liquidity through these cycles is essential for long-term success.
• Sector Vulnerability: Export-oriented small-caps, particularly in technology and manufacturing, can face margin pressure from tariffs and global trade policy shifts.

Balancing these risks requires a disciplined approach and broad diversification across industries and business models.

Why Small-Cap Exposure Matters for Investors

Small-cap exposure adds diversification to portfolios that may be heavily weighted toward large, mature businesses. Because smaller companies are often in earlier growth stages, they can provide access to emerging sectors and structural trends less represented in broader indices.

Small-caps remain cyclical, but history shows that periods of pessimism often precede extended performance runs. As valuations normalise and macro conditions stabilise, disciplined investors can benefit from patient capital allocation.

When selecting a small-cap fund manager, investors should consider:

• Experience across cycles: Managing small-caps requires an understanding of liquidity risk and earnings volatility through both expansions and contractions.
• Depth of research: The best opportunities often exist in less-covered companies, so a manager’s ability to conduct independent, bottom-up analysis is critical.
• Alignment of interests: Managers who invest alongside their clients demonstrate confidence in their own strategy and discipline in risk-taking.
• Portfolio construction: Diversification within the fund, across sectors, balance sheet strength, and growth stages, can help reduce idiosyncratic risk.

These factors distinguish small-cap strategies that simply follow momentum from those built to deliver sustainable long-term returns.

How Datt Capital Approaches Small-Cap Investing

At Datt Capital, small-cap investing is grounded in rigorous primary research and long-term alignment with investors. Our Datt Small Companies Fund focuses on identifying undervalued or overlooked businesses with resilient balance sheets, clear earnings visibility, and structural tailwinds.

Independent Research Process

Our research team applies a mosaic approach, drawing insight from a wide network of industry data, regulatory filings, and sector experts. We avoid reliance on consensus broker research, preferring to form our own conviction through first-hand analysis.

Focus on Quality and Liquidity

We prioritise companies with durable competitive advantages, prudent capital management, and sufficient liquidity to manage portfolio flexibility. The objective is not only to capture upside but also to control downside risk when market sentiment shifts.

Alignment with Investors

Every principal at Datt Capital invests personally in the firm’s funds. This direct alignment ensures decision-making remains focused on protecting and compounding investor capital.

Through this framework, we aim to capture the asymmetric opportunities that small-caps offer while managing the volatility inherent in this segment.

Conclusion

Small-cap funds continue to demonstrate resilience as economic conditions improve. Valuations are supportive, earnings momentum is turning, and rate expectations are creating a constructive backdrop for growth.

At Datt Capital, we view the small-cap universe as a fertile landscape for original research and selective opportunity. Our disciplined, research-led approach focuses on finding companies with enduring fundamentals, positioned to benefit from recovery cycles.

To learn more, visit our Small Companies Fund or explore our investment philosophy. For further information, contact Daniel Liptak, our Head of Distribution, at daniel@datt.com.au.

Investor FAQs

1. What are small-cap funds?
Small-cap funds invest in companies with smaller market capitalisations, typically outside the ASX 100. They aim to capture higher growth potential over time.

2. Why do small-caps rebound faster after downturns?
Smaller companies are more responsive to improving economic conditions and benefit earlier from rising demand and easier financing.

3. Are small-cap funds riskier?
They can be more volatile than large-caps, but diversification and active management can help manage that risk.

4. How can investors access small-cap exposure?
Through active managers such as Datt Capital, which applies detailed research and portfolio discipline via the Datt Small Companies Fund.