While most businesses find rising interest rates difficult, Australian smaller companies have had to navigate a confluence of challenges since May 2022, when rates started rising again:

• Rising interest rates restrict a small company’s access to funding. When a small company is early in its growth phase, it may not produce much revenue and so needs to borrow money to fund its operations and strategic plans. When interest rates are rising, this funding is both harder to get and more expensive.
• Consumers spend less when interest rates are high. The ASX Small Ordinaries index has a larger exposure to consumer discretionary companies. These are companies in industries such as travel, lifestyle retail, home electronics and education – representing 17.4% of the ASX Small Ordinaries index versus 5.8% of the ASX 100. When consumers are under pressure, investors usually sell down their investments in consumer discretionary companies.
• Investors generally prefer larger companies when investment markets are uncertain. Given the effect of high interest rates on smaller companies, larger companies can be relatively more attractive to investors. In turn, it can be harder to sell the shares of smaller companies because there are fewer investors wanting to buy them, depressing smaller company prices.

Looking to the future, some central banks are indicating that interest rates could be reaching their peak. This means that funding and other interest rate challenges could lessen for smaller companies. In turn, investors are starting to become interested in small cap growth opportunities again.

The August 2023 reporting season showed the resilience of corporate Australia. Dividends remained strong and concerns about the impact of inflation, labour costs, freight costs and interest rates are resolving.

So as the interest rate outlook improves, the profits of some small-cap companies could lift. And with less uncertainty, more investors could find smaller companies a hunting ground again for growth, taking advantage of the lower prices for smaller companies versus larger companies.

What’s more, because there’s a broader range of industries represented in the ASX Small Ordinaries versus the ASX100, investors seeking diversification are also more likely to consider smaller companies.

In addition to the risks of share market investing generally, some risks loom larger for smaller companies, such as:

• When inflation and interest rates increase, smaller companies are generally harder hit than larger companies.
• Weaker economic conditions can be more challenging for smaller companies as they often don’t have the pricing power or brand strength of their larger competitors.
• While some smaller companies have robust operations that generate consistent profits, others carry quite a bit of capital and earnings risk for investors.

For example, mining companies in the exploration or mine development phase may not deliver the returns the company envisaged.

Because the ASX Small Ordinaries Index includes a broad range of companies with very different risk profiles, a professional investment manager can sort the stronger companies from the weaker ones. They do this through deep research into each company. And because they understand the risks and opportunities that are unique to this sector, they can pick the best times to buy in and sell out of a company.

So as the interest rate outlook improves, the profits of some small cap companies could lift.