It is often difficult to pinpoint exactly why certain sectors of a sharemarket become cheap relative to others. Even harder is pinning down the catalyst that will bring the valuation pendulum back into a more sustainable position. Hardest of all though is getting the timing right – the point in the cycle when this catalyst will actually take effect.

We tend not to obsess about the catalyst or the timing. Instead, we look for the pendulums that are at or near an extreme; those companies or sectors which we think are likely to reward investors handsomely when the pendulum rights itself.

Relative to large companies, Australia’s small capitalisation shares are nearing extreme valuations. The graph illustrates this and plots the performance of the S&P/ASX Small Ordinaries Accumulation Index relative to the S&P/ASX 100 Accumulation Index (the largest 100 companies).

Performance of small companies relative to large companies in Australia

Source: Iress, S&P/ASX Small Ordinaries Accumulation Index relative to the S&P/ASX 100 Accumulation Index

Despite the small end of town having rebounded a little from its early-2015 lows, it has significantly underperformed over the past 20 years and has underperformed the top 100 by 7% in the 2017 financial year alone. It has been argued that this is the result of a shift to passive and ETF investing, where it is possible to replicate 87% of a market’s exposure with the top 100 share positions. It’s not clear – this shift to passive investing is a global phenomenon but it hasn’t resulted in similar underperformance of small capitalisation stocks in other large developed share markets. More important than identifying the reason behind the pendulum’s shift is determining whether it is permanent or whether it will return to its swing path. We believe the significant underperformance of this sector to be temporary.

The table shows that, relative to its benchmark, the Australian Equity portfolio has over three times more (by portfolio weight) exposure to companies outside of the largest 100 shares in the S&P/ASX 300 Accumulation Index. It is in this segment of the sharemarket that we see some of the most attractive investment opportunities and you can read more in our latest Quarterly Commentary.

Weighting of large and small companies in the benchmark and portfolio

Source: Iress, weights in the S&P/ASX 300 Accumulation Index and the Allan Gray Australia Equity Strategy

Simon Mawhinney holds a Bachelor of Business Science (First Class Honours) with majors in Finance and Business Strategy and a Postgraduate Diploma in Accounting (University of Cape Town). Simon qualified as a Chartered Accountant in 1998 and is a CFA Charterholder.

Figures are at 30 June 2017 unless otherwise stated.