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.”