Why invest in huge multi-nationals when the real high growth opportunities are among smaller companies – commonly called small cap?
It is certainly true that smaller companies, or small caps, can provide stellar returns for investors. But small cap stocks that have little track record to speak of are higher risk too and may leave investors licking their wounds.
What is a small cap?
The definition ‘small cap’ is not overly precise. Small cap in the UK stock market would typically be companies with a market capitalisation of between £150m to £500m.
Those with a market cap below £150m would likely figure on the Alternative Investment Market (AIM). These stocks are often referred to as micro caps but still figure (though often to a lesser extent), in small cap funds.
In the US, small caps are generally bigger – so a $2bn market cap business would still be classed as a smaller company. In the UK, a company of this kind would be classified as mid cap stock.
Do your homework
Whether you are investing in UK or US small cap stocks, the same rules typically apply. Don’t invest in something you don’t understand.
The levels of research on smaller companies is far less comprehensive than for mid and large caps. Professional analysts heavily concentrate on larger companies.
If you put in the ground work and research a sector and then dig down and identify undervalued stocks within it, you might turn a good profit.
Not only are smaller companies less researched but they do usually offer better growth potential. This is because it is feasible to double or quadruple the sales of a smaller company whereas with a large cap name, such as BP or GSK, this would be nigh on impossible.
‘Elephants don’t gallop’ is how investment guru Jim Slater refers to large caps. He opts for nimble small caps over elephants. Because of their size, small caps can move quickly – the decision- making process is quicker as the management chain is far more streamlined.
Getting a blue-chip company to change course is like trying to turn a cruise liner.
Greater growth potential is the great attraction of small cap companies. However, the downside is that they are less liquid (their shares are harder to sell) so they are riskier for investors.
Even if a smaller company has great potential and is hugely innovative in its field, this is no guarantee that it will prove a success. If there are no barriers to entry, a hungry company could steal their customers and step in to take the lion’s share of the market.
Alternatively, the small cap could have a fabulous product but an awful business model – it could try and expand into new market too early. It might be over-ambitious in its growth planning and take on huge debt that becomes crippling.
There is no shortage of small businesses that have failed, not through poor product design but due to poor management. If you have put all or most of your money into a hugely promising small cap that simply runs out of capital, you could be sitting on near-worthless shares.
Smaller companies tend to be less resilient than larger firms, so if the economic conditions change and demand plummets, they do not have the same reserves to draw on.
The good the bad and the ugly
Go beyond the glossy corporate brochure or annual report and you might discover that a company is far from the healthy specimen it claims.
This is why researching a smaller company should always include a focus on the senior management.
· What are they saying?
· Are they transparent concerning their future plans?
· How is their advertising and marketing shaping up?
· Are there any useful nuggets in articles in the trade press or hints in the company’s interim or final results?
If you work in a particular sector, say for instance civil engineering or construction, you may have particular insight that can be drawn upon when identifying good value smaller companies in your area of expertise.
While using insider knowledge of an industry makes good sense, it doesn’t mean small cap investors can ignore the merits of diversification. Knowing a sector inside out is scant consolation if companies within it are hammered and all your money is tied up there.
It is perfectly conceivable for an individual trader to construct their own diversified portfolio of small cap stocks. However not everyone has the time and wherewithal to monitor their portfolio on a daily basis.
As Neil Mumford, chartered financial planner at Milestone Weatlh Management explains, small cap DIY investing is not for everyone and collective funds are the preferred option.
“Small caps are notoriously difficult to research and it is not just a question of a day trader looking at figures and trends. Fund managers interview company directors and in some cases, will have significant stakes in small companies – as much as 30%. It is not uncommon for the fund manager to be the largest shareholder, which means they will be well aware of the ‘ins and outs’ of the company.”
He adds: “They also tend to be long tern investors and not sell out on market sentiment, which is where individuals make mistakes.”
With a collective fund, the day-to-day stock selection is in the hands of a fund manager who is backed by a full-time team of analysts.
In theory, their increased resources should promise greater returns than a DIY armchair investor. The reality is that some smaller company funds do demonstrate a good track record over a meaningful time period (3-5 years) while others fall well short of the mark.
It is important to compare like with like. A UK smaller companies fund will have little correlation with a US or Japanese smaller companies fund. But there might also be a distinct different make-up of two, similarly labelled, funds.
For instance, one fund could primarily focus on larger UK smaller companies and mid-caps, such as the Aberforth Smaller Companies Trust. Another could be more exposed to micro caps of £100m-£150m – for instance the Marlborough UK Micro Cap Growth fund or the Axa Framlington UK Smaller Companies fund.
Closed or open-ended?
Mumford argues that investors preferring a collective option might benefit from choosing the closed ended investment trust over the open-ended unit trust fund.
“You will see in the case of Standard Life, that the closed ended vehicle has significantly outperformed the open ended over 10 years and the 20-year return is truly amazing.”
He adds: “It is true that at times closed ended will trade at significant discounts but they do not have to worry about outflows and therefore can stand by their convictions in falling markets. These funds are for long term investors and will suffer significantly in market downturns, so are definitely a buy and hold and not for the faint hearted.”
Private equity and VCTs
What other ways can investors access potentially high-growth smaller companies. Options include private equity funds and venture capital trusts (VCTs).
Private equity enables direct investment in private companies. Institutional and retail investors provide the capital for private equity, and the capital can be used to grow the business through acquisition or investment in IT, equipment or premises.
It can also be used to strengthen the balance sheet and allow entry into new markets. While private equity is available to retail investors, the large minimum investments required and hefty fees, mean they are predominantly suited to the higher net worth individuals.
The private equity market has grown significantly in recent years with many investors claiming that private equity outperforms the public stock market over time.
But aside from the large initial investment and charges, private equity funds are not for everyone. PE Investors will often have to wait some time for a company turnaround or an IPO to be concluded before they see any profit.
VCTs are another option for small cap investors. Like private equity funds, they are a higher-risk, longer-term investment. Minimum investments are higher than for standard unit trust funds.
But for those willing to take the risk and with broad investments elsewhere, Martin Bamford, chartered financial planner at Informed Choice, believes VCTs serve a useful purpose. “For investors looking for tax breaks, Venture Capital Trusts are a good option to consider and there are several managers with long experience investing in smaller companies.”
Small cap investing: successes and failures
Anyone old enough to remember the dotcom boom will probably remember the spectacular fall from grace of Boo.com.
Like many fledgling online businesses of the time, Boo.com offered investors something new. And there was no shortage of capital to invest in the company’s growth – initially at least.
Boo.com managed to spend the best part of $140m in investor capital before faith in dotcoms began to wane and with it the ready cash.
The brand name itself had issues – asked what Boo.com sold, most people in the late 90s had heard the name but had no idea it sold training shoes and clothes. In contrast, you could hazard a guess what lastminute.com’s business was and you’d probably be right.
Essentially Boo.com went under because it tried to run before it could walk. It’s expansion plan to launch Europe-wide was not just ambitious, it was unrealistic. The company under-estimated the costs required to grow the business at the rate it planned. Investors understandably got the jitters when the site launch date was repeatedly delayed.
Matters where not helped by a misjudged free returns policy – which while free to the customer cost the company dearly in courier charges. By 2000, Boo.com was no more and the company’s assets were sold for a pittance.
Investors learned a valuable lesson after the dotcom bubble burst – jumping on the bandwagon and buying hugely over-valued stocks with no history to speak of, usually spells disaster.
While Boo.com represents the biggest dotcom flop; Amazon is a prime example of a dotcom triumph.
Founded in a garage in Seattle by Jeff Bezos, Amazon launched itself as the first online bookstore in 1995. It listed on the NASDAQ stock exchange just two years’ later. The initial public offering (IPO) was targeted at $18, but by the end of the day, demand had pushed the share price to $24 per share. Amazon.com shares are currently worth just over $980.
While the company’s share price took a hammering when the dotcom bubble burst, unlike Boo.com, Amazon survived not least because its business model was better. Rather than try and expand its offering too soon, Amazon added films, music, electronics, and then eventually a whole range of goods gradually as the company developed its capability.
In a relatively short time, Amazon has evolved from an online bookstore to a retail giant. It currently employs almost 270,000 people worldwide and has a market cap of just over $471bn.