Why ASX small-cap shares could be set to soar (2 stocks mentioned)

Some fund managers have explained why it's time to take a closer look at the small end of the market.

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Some experts believe ASX small-cap shares can generate particularly strong returns following periods of extreme volatility.

For example, principal and portfolio manager at Lennox Capital Partners Liam Donohue wrote in last week's Sydney Morning Herald:

History doesn't repeat, but it does rhyme – and if this adage holds true, small caps are likely to present strong opportunities for patient investors over the coming years.

He noted that the S&P/ASX Small Ordinaries Index (ASX: XSO) fell by over 20% in the 2022 calendar year, and that's one of the largest drawdowns in the benchmark's history. Donohue disclosed some research Lennox had undertaken, which showed a strong recovery could be on the cards:

Our analysis shows that if you were to invest immediately following a drawdown year of -10 per cent or worse, the average compounded return for the three years following would deliver 35.2%.

The caveat is that you need to remain in the market to enjoy the recovery. So, as investors ponder when is the right time to re-enter small caps, we suggest focusing on time in the market as opposed to timing the market.

Why could ASX small-cap shares be set to shine?

Lennox Capital Partners isn't the only fund manager that sees the small end of the market as an opportunity right now.

Last week, investment specialist Chris Robinson from Firetrail pointed out that while small caps have been underperforming large caps, historically, this imbalance has created a "highly attractive entry point for savvy investors". Robinson said:

Small caps are now trading on a material discount to their historical relative valuations versus large caps, despite a strong medium-term growth outlook. With other big tailwinds now emerging, we believe now is one of the best times in history to invest in Aussie small caps.

He suggests that not only is the ASX Small Ordinaries Index now trading at a meaningful discount to its historical relative valuation to the larger caps, but ASX small-cap shares are projected to grow earnings by an average of around 17% per annum over the next three years, compared to 1% for their large-cap peers.

Firetrail believes that some businesses are being priced for potentially weak earnings in FY24, without accounting for an improving outlook on a three-year view.

The fund manager sees Nick Scali Limited (ASX: NCK) as a 'value' ASX small-cap share opportunity, believing the company is more resilient than current pricing reflects, and that it's undervalued on a three-year outlook.

Firetrail also sees Life360 Inc (ASX: 360) as a growth opportunity thanks to rising subscriber numbers and price increases.

Even if the market doesn't send share prices of ASX small-cap shares higher, Firetrail's Robinson suggested that their relatively lower prices could attract acquisition interest.

He went on to say that the weakening Australian dollar makes it easier (and cheaper) for overseas private equity players to justify paying a premium to the market valuation.

So, if there is any validity to what these two experts are saying, ASX small-cap shares could present a compelling investment opportunity right now.

Motley Fool contributor Tristan Harrison has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended Life360. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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