As 2025 unfolds, small-cap stocks are positioned to potentially add significant value to investors’ portfolios. Here are five compelling reasons why small caps can steal the spotlight this year.

Benefits from rate cuts

Small-cap companies often have a capital structure that is more sensitive to short-term interest-rate movements. After central banks cut rates, the debt servicing costs for these companies become less burdensome, potentially leading to better performance within the small-cap segment.

Exhibit 1: Domestic interest rates (%) versus Australian small-cap market returns

Exhibit 1: Domestic interest rates (%) versus Australian small-cap market returns

Source: Maple-Brown Abbott, Data as of Jan. 28, 2025.

The co-portfolio managers of the Maple-Brown Abbott Australian Small Fund rated Silver by our research team, Phillip Hudak and Matt Griffin, are saying “Historically, interest-rate cuts have resulted in subsequent positive performance at the smaller end of the domestic equity market.

Last year, the RBA was uncoordinated with other central banks, remaining more hawkish, given stickier domestic inflation, although have recently recast a more dovish tone with interest-rate cuts expected to commence in the first half of the 2025 calendar year with the market factoring in close to 0.75% reduction by year-end. This setup is expected to be supportive and renew investor interest for Australian small caps".

Attractive valuations

Currently, small caps are trading at a substantial discount compared with their large-cap counterparts. Historically, such a discount has been a precursor to a significant price appreciation for small caps, especially if market sentiment changes positively.

Ned Bell, portfolio manager of the Bell Global Emerging Companies, rated Gold by our research team, said about the global small- and mid-cap companies "SMID Cap equities trade at a Price/Earning (P/E) of 16.4x versus 19.2x for the MSCI World Index. Over the last 10 years, SMID Cap equities have traded at a 5% premium to the broader market. In other words, if SMID cap valuations were to re-rate to historical norms, they would be trading on a P/E of 20.2x."

Exceptional growth prospects

Projections indicate that small caps are set to experience significantly higher earnings growth than large caps in 2025. Faster growth means that these companies might offer more robust returns for investors chasing growth opportunities.

In the domestic market, "stocks like Hansen Technologies (ASX:HSN) might benefit from a favorable outlook at the smaller end of the market relative to large cap," states Phillip Hudak. HSN offers critical billing and customer care solutions, with a strong recurring revenue base and high margins, benefiting from the energy transition and recent acquisition synergies. HSN generates strong cash flow, has a solid balance sheet for acquisitions, and trades at an unjustified discount to peers despite its defensive characteristics and growth prospects.

In the US, stocks like Clean Harbors (NYS:CLH) and Core & Main (NYS:CNM) have attracted the eyes of Ned Bell as "the opportunity set in the hazardous waste industry is attractive and growing as the number of incinerators declines and opportunities in PFAS* materialize, there is real scope for the company grow earnings by +50% over the next 2–3 years" and " the largest standalone waterworks / fire protection distributor in the U.S. is expected to benefit from increases in water infrastructure and we can see scope for the earnings to grow by 15% p.a. for the next 3 years."

Reshoring boost

In a shift of global trade dynamics, many large multinational corporations are now bringing their supply chains back to domestic shores. This "reshoring" trend is expected to benefit small caps predominantly operating in local markets. Additionally, this shift could spur mergers and acquisitions, or M&A, activities, with larger firms looking to acquire smaller businesses to capitalize on the benefits of reshoring.

Codan, or CDA, has been identified by Matt Griffin from Maple-Brown Abbott “Given ongoing heightened geopolitical tensions, de-globalisation, and onshoring of defence production and supply chains, we see increasing global defence spending as being a structural growth thematic. Codan Limited (ASX:CDA) is positively exposed to this theme via their expansion of communication services for military and emergency response. The company has a strong track record of innovation with sustained levels of engineering investment and has focused on expanding the product suite to grow the total addressable market, via widening the range of customers and industry verticals. In addition, the company is building more predictable and recurring revenue streams with the strategy being enhanced by aligned acquisitions, which offer enhanced scale, core business expansion, increased penetration in adjacent markets, and complement existing technology and market exposures.”

Advantages of market concentration

History has shown that following periods of heightened market concentration, small caps generally outperform. Given the current market climate, this trend could very well continue, rewarding those who invest in the smaller yet nimble players in the market.

In sum, 2025 could very well be the year small caps shine, offering opportunities for investors willing to embrace a bit of risk for potentially rewarding returns.

* Per- and polyfluoroalkyl substances are a group of synthetic chemicals that are resistant to heat, water, grease, and oil. They are also known as "forever chemicals" because they are difficult to break down.