People often ask me why do I invest mainly in small-caps. When I reply, “why not?” I get the following answers:
- Penny stocks are risky! I will only invest in the more stable blue chips (large caps)!
- Smaller companies cannot beat the MNCs!
- The small fries are first to get wiped out during a recession, interest rate hike, etc.
- Small-caps have poor liquidity! It’s so hard to get in and out because the spreads are so large!
- Too much corporate governance issues! What if there’s fraud? Look at ABC Ltd (Referring to an S-chip)!
While the above points are valid to a certain degree, it is because of such widespread negative reputation that small-caps have that allows considerable money-making opportunities to go unnoticed.
I believe that as an asset class, small cap is one of the most widely misunderstood and underinvested among investors. Here are the top 5 reasons why I believe small-caps make better investments than large-caps:
1. small companies make BIG moves, LARGE companies make small moves.
In the long run, a company’s earnings power determine its enterprise value. For a company’s value to double, it has to earn twice the amount it did before. Which is easier, doubling the earnings of a small famous chicken rice shop, or doubling the earnings of McDonalds?
Thats why small cap is the land of the multi baggers, it offers growth, something large caps can’t offer much of. It is also worth noting that ALL large caps today were once fast growing, share price soaring “risky” small caps too.
2. Small companies are less affected by global market trends.
Small companies are driven by local market dynamics and are therefore less dependent on global market trends. The economic fate of small caps have more to do with internal factors (can control) than external ones (cannot control).
For example, llao llao’s success lies in its ability to scale without compromising on its quality. llao llao doesn’t care if China slows down, Fed hikes interest rates, or ECB continues with its QE program. llao llao only cares about executing its growth plans well.
Small companies are also more nimble to adapt to the ever-changing economic environment vs. large caps.
3. Small caps are less volatile (risky) than large caps.
Since small companies are less affected by global market trends and more affected by local market dynamics, they are less correlated with one another. Due to their sheer size, large caps are more affected by global market trends and are more correlated with one another. When the market experiences a downturn, most large caps are dragged down along due to their high correlation, even if their business remained robust.
4. Small caps are under-researched and underinvested.
Due to their small market capitalisations, financial institutions (FIs) are unable to obtain a sizeable position in the company to make a significant difference to their portfolios. For example, owning 10% stake in a small cap that doubled its share price in a year may not mean a lot if the small cap only constituted 1% of the total portfolio of a FI.
The lack of interest in small caps disincentivises research houses from writing research reports on them.
This leads to a unique situation. When adequate research is done by the investor, small caps can be bought at cheaper valuations despite having greater growth prospects!
5. Small caps make great acquisition targets.
In today’s growth-starved environment, large companies find it hard to grow organically. So MNCs either consolidate and/or acquire smaller companies to fuel growth. A buyout is usually priced near the intrinsic value of the acquisition target, in order to entice shareholders to accept the offer. This causes the share price to instantaneously adjust to at or near the intrinsic value.
This presents the investor with the opportunity to cash out at maximum profit potential within a shorter intended holding period. The investor is then able to recycle the capital into another undervalued investment and further compound his wealth.
While the size of a company tend to be inversely proportionate to its growth prospects, what is more important for investors is to have a robust bottom-up stock selection process. So instead of blindly picking small cap stocks, one will be able to sift out the Goliaths of tomorrow.
Small is Big. Small is Beautiful.