By Rajasik Mukherjee

(Reuters) -Long overlooked as the backwater of the Australian equity market, small-cap stocks are having their best run in over a decade due to strong earnings and growth potential, as pricey blue-chip stocks have sent investors seeking value elsewhere, fund managers say.

Powered by robust earnings, easing interest rates and a policy tailwind for critical minerals, the ASX Small Ordinaries Index, which tracks companies valued at between A$200 million ($130 million) and A$10 billion, has raced ahead with a nearly 21% gain since the start of this year. That sharply outpaced the ASX 200 benchmark index's return of about 8%, both as of Wednesday's close.

By that measure, the small-caps index is headed for its best year since 2009, reflecting an aversion among some parts of the market to blue-chip banking stocks whose prices have skyrocketed since the central bank began its easing cycle earlier this year.

These factors have "prompted investors to look further down the market for value and growth, giving small-caps a relative bid they haven't enjoyed in years," said David Tuckwell, chief investment officer at ETF Shares.

"The small end of the ASX has long carried the stigma of being a bit of a 'dumping ground', the place companies go once the market loses interest," Tuckwell said.

SMALL CAP INFLOWS SURGE

A surge of inflows in wealth manager Betashares' Small Companies Select ETF has seen unit allocations, an indicator of inflows and outflows, up 163% through October, versus 27% growth in its Australia 200 ETF.

Meanwhile, the iShares MSCI Australia ETF, seen as a benchmark for foreign interest in Australian blue-chips, has seen allocations drop 13%.

The small-cap index is trading at a price-to-earnings ratio of about 11, versus almost 20 for the benchmark blue-chip index, according to LSEG data, underscoring the value appeal of small caps.

Hugh Lam, an investment strategist at Betashares, pins the rally on a supportive macroeconomic environment, marked by robust gross domestic product growth.

"GDP growth ... tends to support cyclical areas of the economy such as consumer discretionary and industrials - two sectors where small caps have greater revenue exposure to," Lam said.

Shares in defence technology firm DroneShield ( DRSHF ) surged 329% this year through their close on Wednesday on a steady pipeline of contracts, strong earnings, and inclusion in the S&P/ASX 200 index.

DroneShield ( DRSHF ) shares slumped 34% on Thursday, their biggest-ever one-day decline, after the company disclosed its CEO, chairman and a director sold shares worth a total of A$66.7 million over a one-week period. Its year-to-date gains remained robust at 195% despite the selloff.

Zip, a buy-now-pay-later firm that cut its teeth in the cheap money era of the pandemic, has seen shares surge around 1,000% since its September 2023 lows.

Favourable critical minerals policy and preliminary funding agreements with the U.S. government have also propelled Arafura Rare Earths and Northern Minerals shares up 130% and 76%, respectively, this year.

WILL AN EXTENDED RATE PAUSE DERAIL THE RALLY?  

While lower interest rates since February have boosted small-caps, fund managers see little risk to the rally from the Reserve Bank of Australia holding off on more easing until next year, as widely expected.

"I don't think the market was ever treating these stocks as an interest rate sensitive 'duration trade'," ETF Shares' Tuckwell said.

Ron Shamgar, head of Australian equities at Tamim Asset Management, sees double-digit upside for small caps through 2026 even if rates stay flat.

"Over the last three years, small caps have underperformed large caps by the widest margin in history, and for smalls to return to trend, there is another 20% upside," Shamgar said.   

($1 = 1.5389 Australian dollars)