For thrill-seeking investors, the small cap end of the market is a double-edged sword. Unlike large cap companies, which offer security but small returns, small cap companies can mean big gains—or big losses—thanks to their relative lack of liquidity and economic sensitivity. This article aims to provide an introduction to investing in small caps on the ASX.
Small cap stocks: a definition
Small cap stocks, as defined by Standard & Poor and the ASX, are those which rank from 101 to 300 in market capitalization on the Australian share market. Small caps, then, are those which fall beneath the S&P/ASX 100 Index but within the S&P/ASX 300 Index. They are benchmarked against the S&P/ASX Small Ordinaries Index.
Anyone interested in small cap stocks must remember that the market capitalization of companies varies over time—and any analysis of data published by financial media must keep that in mind. Remember, too, that the term “small cap” is arbitrary. Some fund managers may call a stock “small cap” while another may define it as “micro cap” or “mid cap.” This difference in definition has implications for performance measurement and the accuracy of comparisons across funds.
Small caps: winners in the upward market cycle
Historically, small cap stocks/funds perform best as the economy exits a recession and enters into a bull market. This is because they are uniquely suited to an economic environment of waxing consumer confidence, increasing retail spending, rising house prices, and a buoyant share market. The fact that they respond so well to these conditions shows that small cap performance is economically sensitive and often cyclical in nature – in other words, volatile.
When the economy is performing poorly, small stocks tend to fare poorly. During an economic recession and bear market, they have historically underperformed. That is not to say, however, that all small cap stocks cannot or do not perform well during recessions. With sound corporate management, small cap companies can provide the flexibility and foresight needed to ride out downward economic trends.
That said, large cap companies are generally better equipped to deal with economic downturns because of their greater liquidity and larger market share—both of which help them to weather the storm. During an economic recession, small companies that earn non-discretionary income, such as capital goods and business suppliers, are better investments than those whose revenue comes from discretionary purchases, such as retailers and the media.
Advantages of investing in small caps
Now that we’ve covered some of the downfalls of small cap investing, we can return to their potential. Provided that the stock selector chooses a good stock or fund manager, small cap investing can prove to be very profitable–so long as it has been accurately determined where the economic cycle is heading.
Small cap investment holds so much potential because the market for these stocks is, at best, semi-efficient. Investors, therefore, have the potential to invest in companies that are undiscovered by the general market. This is nearly impossible to do in the large cap market.
The money behind small caps: earnings growth potential
Because they start from a lower base, any increase in dollar amount of earnings for small caps is a greater proportion of their current value than large caps. Since smaller companies are better positioned to double in size or earnings than large companies, this gives small caps a higher earnings growth potential—and the chance to give a larger return on an investment.
Small caps’ diversification benefits
Investors in small cap funds can gain exposure to stocks that are less likely to be found in mainstream share funds—diversifying and enhancing their portfolio.
Potential to outperform
Unlike large cap fund managers, small cap fund managers often expect to outperform the market, rather than just track the index. Of course, large cap funds tend to rise or fall in unison, thanks to their general commonality in stock holdings. With small companies, however, there are greater opportunities for investors to profit from specific small cap funds, if they choose a fund that is skilfully managed and consisting of stocks with significant earnings growth potential.
Small caps, smaller portfolios: greater flexibility
As the points above indicate, flexibility is the advantage small cap fund managers have over large cap fund managers. This is primarily due to the fact that small cap managers manage portfolios with less holdings, conduct their own research, and work hard to outperform the index. Typically, small cap investors become more willing to take risks and invest in companies that align with their own convictions about the direction of the economy or industry.
But there is another key component of this flexibility: small cap companies are themselves able to better respond to opportunities and market influences thanks to their smaller size. Adaptation comes harder for large cap companies, who find it hard to change their business mix.
Cheaper than large caps
Because of the relative lack of research available on small cap stocks, they tend to cost less—making it cheaper to invest in higher quantities. Still, this lack of research is part of what makes small caps more risky than large ones: investment decisions are justified by research. In fact, with large caps the cost of research is factored into the total cost of investing. For small caps, though, the research simply doesn’t exist. Most brokers and analysts are generally unwilling to spend the time and money on researching thinly traded stocks because they cannot easily recoup the research cost from transaction volumes.
This is a major factor in the conception that the small cap portion of the market is less efficient than the large cap segment.
The influence of small cap fund managers
The investment decisions of small cap fund managers are, as discussed before, based heavily in thorough research and personal conviction about the individual companies themselves. Small cap investors, then, tend to be better at seeing through “management spin” to focus on the true issues of capital allocation and actual returns.
Thanks to this, some small fund managers even come to exert influence over the management, development, and growth of small companies. Investors benefit from choosing investment teams that are skilled in identifying and influencing the proper companies—and in turn reap larger fund returns.
Disadvantages of investing in small caps
The primary downfalls of small cap stocks/funds investment is the relative lack of liquidity these securities have when compared to large caps and their economic sensitivity, which renders them almost entirely at the mercy of the market cycle and thus more volatile than large caps.
Lack of liquidity
Small companies often have directors or other key personnel hold a large proportion of their company shares, making them long-term investors. This decreases their liquidity. Additionally, funds that do invest in small caps may have trouble finding buyers for their stock—keeping them stuck with a poorly performing security.
Small caps: uncharted territory
Small caps suffer from a relative lack of research compared to large cap stocks. Therefore, the responsibility of research falls on the interested small cap investor, who must accurately identify opportunities for growth and then buy and sell at opportune times. Investors have the opportunity to out-perform the market if they play their cards right, but they also have a higher chance of making an incorrect investment decision.
Volatility
As we discussed previously, small caps are more affected than large caps by economic cycles. Corrections in the stock market usually bring small cap underperformance. When the public’s confidence in the market begins to fail, nervous investors tend to flee towards safety— i.e. to large stocks with steady dividend flows. In such an environment, small companies are perceived by investors as risky investment options. Turning from small caps, they build up positions in the large cap end of the market.
Economic signals that a bear market is arriving and that the small cap end of the market will experience a downward slide include rising levels of consumer debt and price/equity ratios that are relatively high.
Risk of fund manager underperformance
Selecting skilled fund managers is critical in order to succeed with small caps. In areas of the market where the information flow is not as good as the large-cap end, finding the right fund manager to both select the right stocks and to purchase and sell them on time means the difference between high or normal returns and low returns. The right fund manager for today is likely not, however, the right one for five years in the future: the unique company and economic situation may privilege one manager over another.
Size restrictions on small cap funds
Small cap managers will often try to preserve existing investors’ positions and seek to close a fund when money under management reaches a certain level, often $500m. Investors, then, may not just be looking for the best small cap manager, but the one that has the fund capacity needed to take additional inflows.
The role of research in small cap selection
The managers of small cap funds base their investment strategies on inner conviction, making the performance of a fund positively correlated to the quality of the investment team and their skill in research, especially in regards to timing and stock selection.
Is the relationship between small cap investment success and the individual investment teams an advantage or a disadvantage? The answer depends. At their best, however, small caps reward careful stock selectors.
Investment styles with small cap stocks
When it comes to making investment decisions regarding small caps, “bottom-up” stock selection is the most common core investment strategy utilised. This approach includes researching microeconomic factors influencing target companies, such as management styles and corporate culture, and using various valuation techniques to price stocks. Elements of “top-down” investment strategies are used, too, to form a view of the market and consider macroeconomic factors and how they might affect the small cap company.
The group Merrill Lynch Investment Managers, for example, uses what they’ve termed a “360-degree” research approach, where one small cap company is targeted and used as a spring board to identify more growth prospects from the target company’s various suppliers and competitors.
Today’s small caps: the large caps of the future?
Small cap companies today may become the mid caps and large caps of the future. Investors, then, not only reap the diversification benefits that accompany small caps, but also have the potential to ride the wave of a small cap’s growth towards becoming a large cap—a very profitable position for an investor if they or their fund manager pick their stocks and time things rightly.
Wrapping up on small caps
Thanks to their economic sensitivity and cyclical nature, small cap stock investing is always a risky business. But higher risk can sometimes be compensated with higher returns, making it worth the while to identify value and growth opportunities in small caps through exhaustive research and a bit of good timing and stock selection skills.
In recent years, small caps have enjoyed high returns due to strong economic growth. Sooner or later, however, a downturn is sure to come and will hit some small cap companies very hard. That said, there are growth opportunities in a bear market for small caps, so long as management is focused, flexible, and able to weather an economic slump.