Investors should always take extra care when experts nominate the same idea. Right now, that idea is buying small-cap stocks for 2025.
One expert after another has tipped small-cap Australian equities to outperform next year and provided a steady diet of hot tips for small- and micro-cap stocks.
I get the logic. On a total-return basis, small-caps have badly underperformed large-caps over the past five years. The S&P/ASX 100 index has an annualised 8.4% return and the S&P/Small Ordinaries Index 4.1% during that period.
Equity strategists who pay close attention to average Price Earnings (PE) multiples in indices have noted the valuation gap between small- and large-caps.
Moreover, small caps tend to outperform when risk appetite rises, and the economy strengthens. With Australian equities near a record high and expectations of rate cuts next year, the backdrop is improving for small caps.
That said, I’m always wary of simplistic index comparisons. Broking coverage of many small caps these days is pretty thin, meaning consensus earnings forecasts and price targets can be based on a handful of analyst estimates.
The boom in passive investing is another consideration. Most fund flows into equity Exchange Traded Funds (ETFs) go into large-caps rather than small-caps. That adds to the opportunity in small-caps, which are not being driven higher by weight of money but also means less tailwind for small-caps from passive funds.
Moreover, I have a more bearish view on the outlook for rate cuts in Australia than many economists. For some time, I have argued that rate cuts here will be delayed due to the strength of our labour market.
There might not be rate cuts until the second half of 2025 if Australia’s hot labour market doesn’t cool. The Reserve Bank won’t cut rates until unemployment rises – a dismal mandate if ever there was one.
As I wrote in this column last week, I expect a market pullback or correction in the first or second quarter of 2025 and a continuing sluggish local economy. If equities continue to rally in the New Year, that should be the time to take profits and preserve capital.
Small-cap bulls betting on imminent rate cuts and a strengthening Australian economy will be disappointed – at least in the first half of 2025.
That doesn’t mean investors should avoid small caps. In the past few months, I have written positively on small-cap ETFs, favouring exposure to US small-caps over those in Australia due to the strength of the US economy.
Rather, investors should beware bullish commentary on the case to buy small caps in early 2025 and be selective. There are always small-cap opportunities and Australia has plenty of terrific small-cap funds.
But basing investment decisions on a hyped-up ‘top-down’ view of an asset class – and investing the same way as everybody else – rarely ends well.
I believe some of the best stock opportunities in 2025 could be in beaten-up, mid- and large-caps stocks. As I wrote last month, I’ve been searching for defensive, unloved large caps with reliable dividend yields. Large caps that can pay me while I wait for their recovery and have less valuation risk after price falls.
Here are three beaten-up stocks for contrarians to consider in 2025, preferably after the market weakens in the first half of 2025 on rate-cut disappointment:
- Woolworths Group (ASX: WOW)
Australia’s supermarket giant has had a horror year. Profit downgrades, legal challenges amid allegations of deceptive discounting, management changes, high-profile strikes, stronger competition from Coles and Australia’s sluggish economy … the list of headwinds facing Woolworths this year was long and strong.
By early December 2024, Woolworths’ shares were down almost 18% year-to-date – an unthinkable fall for the former market star. Over five years, Woolworths’ shares are largely flat, such has been the company’s fall from grace.
That’s the bad news. The good news is Woolworths still dominates supermarket retailing, has a defensive business (people still need to eat if the economy slows) and is under immense pressure to fix things quickly.
Woolworths is no screaming buy. But after heavy price falls this year, Woolworths is trading just below the consensus price target of $32.60. A forward dividend yield of 3.4%, more after franking, provides some comfort.
Although Woolworths faces significant problems, I can’t see it having another year like 2024. Its valuation has priced in a lot of bad news, and possibly too much.
Chart 1: Woolworths Group
Source: Google Finance
- Ramsay Health Care (ASX: RHC)
It’s been a few years since I wrote about the hospital giant in this column. I lost interest in Ramsay after it rallied in 2022.
Ramsay has had an awful few years by its standards. From a peak price of around $84 in April 2022, the stock has slumped to $35.59. This year has been brutal, with Ramsay shedding almost a third of its value.
Like Woolworths, Ramsay has a long list of problems. They include disappointing earnings; rising cost pressures, notably around wages; poor performance from its European hospitals, concerns about safety standards in parts of its hospitals; and investor angst about its overseas expansion strategy.
None of this will be easy to fix for new CEO Natalie Davis, who came to Ramsay from Woolworths, where she ran its supermarket division. Davis is experienced in running businesses being attacked from all sides.
Morningstar’s valuation of $62 a share suggests Ramsay is materially undervalued at the current $36. I’m not as bullish but see emerging value in the entrenched leader in private hospitals in Australia, given its leverage to long-term growth from an ageing population and rising demand for health services.
Ramsay’s recovery will take time and there might be more pain before gain in the short term. For long-term investors who can look through current volatility in Ramsay, it’s an opportunity to buy a high-quality company below intrinsic value.
Chart 2: Ramsay Health Care
Source: Google Finance
- IDP Education (ASX: IEl)
IDP Education was a favourite stock of mine for years due to its leverage to the boom in international students in Australia. Student placement services and English-language testing contribute most of IDP’s earnings.
After tumbling during the COVID-19 pandemic in 2020, IDP shares soared almost threefold to around $37 in late 2021. The stock has since plunged to $11.85.
Proposed regulatory changes in key markets for international student placements, including Australia, have thumped IDP. So, too, have plans to cap international student numbers here in response to community concerns over high immigration levels and the rental crisis.
IDP’s best days might be behind it, at least in terms of its market valuation. Expect its FY25 earnings to fall and any recovery to be hard-won and lengthy. Uncertainty around international student arrivals is a huge headwind for IDP.
Still, at $11.85, the market is valuing IDP at levels last seen during the COVID-19 pandemic when our borders were shut. The negativity has gone too far.
For all its challenges, IDP has a cracking business through its part-ownership of IELTS (International English Language Testing Services). IELTS faces more competition, but there is still a lot of long-term growth ahead for English-language learning as more people from developing nations look to study at Western universities (and require English-language proficiency to do so).
IDP needs to boost its student-placement services, which have never fully recovered after COVID-19. In some ways, regulatory caps could help IDP increase market share in the medium term as students seek higher-quality student-placement services to help them gain entry to universities offshore.
Either way, IDP looks undervalued for experienced, long-term contrarians with higher risk tolerance. The consensus price target for IDP of $18.53 is too high, but even at lower levels offers a reasonable margin of safety based on the $11.85 share price.
Chart 3: IDP Education
Source: Yahoo Finance
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 18 December 2024.
