The Value In Small Cap Stocks
A company with a market capitalisation of $300 million — $2 billion is regarded as a small-cap stock.
Small-cap stocks can sell for as high as $100 a share and they are regarded as high-risk in the stock trading world. They come as high-risk because they are closer to zero, the company is yet to stand the test of time, and institutional investors (market makers) are limited or not allowed to buy small-cap stocks by regulatory authorities. All in all, it doesn’t offer the stability large-cap stocks or blue-chip stocks have Stability.
Why Consider Small-Cap Stocks?
Despite their level of risk — which I’ll touch later on — they have a few advantages as well. Below are three of the most compelling reasons why small caps deserve to be in every investors’ portfolios.
- Huge Growth Potential
Most successful large-cap companies began as small businesses. Small caps give the individual investor a chance to get in on the ground floor of younger firms that are bringing new products and services to market or entering new markets altogether. Everyone talks about finding the next Facebook, eBay or Amazon, they were all small companies once upon a time— diamonds in the rough if you will. Having the foresight to invest in this kind of companies from the beginning, even with a modest commitment would have ballooned into impressive returns.
Because small caps are just companies with small total values, they have the ability to grow in ways that are simply impossible for large companies. A large company with a market cap in the $1 billion to $2 billion range, doesn’t have the same potential to double in size as a company with a $500 million market cap. At some point you just can’t keep growing at such a fast rate or you’d be bigger than the entire economy! Although some large caps are bigger than the Nigerian Economy already.
Mature companies have limited organic growth — the growth rate a company achieves by increasing output and enhancing sales internally. It doesn’t include profits or growth attributable to takeovers, acquisitions or mergers — rates because they already address a larger proportion of their target market. Any new product or service represents a smaller proportion of total revenue than the established product offering. For these reasons, earnings and cash flow growth in large-cap stocks can be limited, unless their corporations acquire other firms. If you’re seeking high-growth companies, small caps are the place to look.
2. Paid Little to No Attention
This is an important attribute. Small caps often have very little analysis coverage and are paid little to no attention from Wall Street as Institutional Investors aren’t allowed at their level unlike those of large cap stocks. What this means to the individual investor is that, because the small cap universe is so under-reported or even undiscovered, there is a high probability that small cap stocks are improperly priced, offering an opportunity to profit from the inefficiencies caused by the lack of coverage devoted to a particular area of the market.
3. Institutional Investors rarely Invest
It isn’t uncommon for mutual funds to invest hundreds of millions of dollars in one company. Most small caps don’t have the market cap to support this size of investment. In order to buy a position large enough to make a difference to their fund’s performance, a fund manager would have to buy 20% or more of the company. The SEC places heavy regulations on mutual funds that make it difficult for the funds to establish positions of this size. This gives an advantage to individual investors who have the ability to spot promising companies and get in before the institutional investors do. When institutions do get in, they’ll do so in a big way, buying many shares and pushing up the price.
The Flaws of Investing In Small Cap Stocks
Two main issues and drawbacks of pitching tents with small cap stocks are addressed below.
- High Risk
Based on market capitalisation category in equity terms, small caps are the second riskiest of five. The other categories from least to most risky are mega caps, large caps, mid caps, small caps and micro caps.
Often much of a small cap’s worth is based on its propensity to generate cash, but in order for this to happen it must be able to scale its business model. This is where much of the risk comes in. Not many companies can replicate what U.S. retail giant Wal-Mart has done, expanding from essentially a small store in Arkansas to a nation-wide chain with thousands of locations. Small-cap stocks usually have smaller customer bases, thus theirs an air of uncertainty about their prospects as their business is more of a region specific one. This can lead to small-stocks going to zero during a rough business cycle.
These stocks are susceptible to high volatility as prices can be changed by less volumes, unlike large caps stocks. They fluctuate about 5% or more in a single trading day, which is something some investors can’t stomach as a loss. The lack of big institutional investors means small-cap stocks have less liquidity, and it makes it difficult for small-cap investors to exit their position during a market panic.
When it’s all said and done, funds you make available for small-cap investing should be one you don’t mind losing completely as it carries greater risk than guaranteed returns from large caps and blue chips
2. Time
It is tedious uncovering what small cap to invest in. Unlike large caps, they are rarely or never covered by news mediums on a daily basis, so getting updates on the go is impossible. You’d have to on your own look for their earnings and develop metrics like growth rates and financial ratios, which are normally published by the media for Large caps.
You would have to take it upon yourself to go through this time consuming and tedious task of developing a report for a small stock so you can make a decision to invest or not.
The Man With The Time and Research Skill
Back in 2008, there was a recession and a collapse of the market. One man knew that collapse would happen as far back as 2005. Dr. Michael Burry, a medical doctor turned fund manager noticed that the lending practices had created a bubble in the real estate that would lead to the collapse of the subprime mortgages market. What it means was that the prices of mortgages bond was higher than the actual value and by the time it would correct itself, a lot of people would lose money as a result of this collapse. People weren’t paying their mortgages and the banks kept refinancing it into new loans with juicier interests. He made a 489% return from shorting the subprime mortgage bonds and the collapse of the market was a chain reaction to the collapse of other markets and eventually the global economy.
Michael is back in the scene, focusing on small caps stocks. He believes that theirs a bubble in the Exchange Traded Funds to which small caps stocks will enjoy healthy returns when this bubble bursts. He noted that he was heavily behind some small stocks in US and South Korea, as they are currently undervalued by Fund Manager whom because of the pressure they face from their clients for guaranteed returns in exchange for the high fees they pay them.
This means that small-cap stocks are not only cheap because they are small stocks, they are even cheaper because their current value is way below their actual values, and once it corrects itself, him, his clients and other investors that followed suit will be smiling to the bank.
