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Investing in Small Cap Stocks – avoid the index trackers and go active

Investing in companies with smaller market capitalisations (small caps) has long been seen as a way to achieve strong capital growth and outperformance.

In fact, over the last 20 years, global small-cap stocks have consistently outperformed their large-cap rivals, even on a risk-adjusted basis.

According to S&P, in the 5-year and 10-year periods to end 2016, 52% and 67% of Australian mid and small-cap funds outperformed the S&P mid-small index, respectively. This fell back a bit in 2017 but by the end of 2018 mid and small-cap funds outperformed the index again.

Despite the evidence that small-cap stocks tend to perform strongly, in recent times a shift toward passive investment options has seen many investors sticking with the major stock indexes such as the ASX 200, which are heavily weighted towards large-cap holdings.

The growth in passive index investing has been driven by two fundamental facts: lower management fees and better performance.

According to S&P’s annual SPIVA survey: “In 2018, apart from the Australian mid- and small-cap funds, the majority of Australian funds did not outperform their respective benchmarks and had worse relative performance than in 2017.” (our emphasis).

The higher cost of active management, combined with the inability of most managers to outperform the index, means that passive investing in large-cap equities is generally a sound investment approach.

But notice the important caveat in the above quote: apart from the Australian mid-and small-cap funds.

Small-cap stocks can be strong investments. Unlike, say, a big-four bank or a large miner, a small-cap stock can double, triple or even octuple in size and still be a good investment. Small companies can be disruptors or invent new business models that sweep up new consumers and hoover up revenues. PolyNovo (PVN), for example, has a market capitalisation 20x higher today than five years ago. That’s unlikely to happen with a BHP or Westpac.

So why not just invest in a small-cap index and buy all those winners? The answer is that for every PolyNovo, there are a bunch of experiments that fail. The small-cap world is where the Darwinian survival-of-the-fittest competition takes place before companies graduate into the mid/large-cap world. Avoiding companies that aren’t going to make it and investing in those that might is how some small-cap managers have consistently beaten the index.

While it’s clear there are investment opportunities within the world of small-cap investing, what are some of the benefits and risks?

Small-Cap Benefits

Growth Potential

As we’ve already established, investing in small-cap stocks (stocks with a low market cap) over the last 20 years has seen strong outperformance compared to large-cap stocks.

On the surface, one of the reasons for this long term outperformance is that small-caps generally are lesser known and have the ability to double or triple in value. This is more often than not due to the fact that these companies are in an earlier stage of their development.

Smallcap companies can grow in value as the different areas of their business grow. Mature, well-established businesses are simply not going to be able to increase their revenue or profit at the same rates as a newer company and that can lead to explosive short term growth potential.

Less Attention

One of the advantages of investing in small-cap stocks is the fact that you’ll be up against far less competition.
All of the large-cap stocks (or blue chip stocks) that are ASX listed will have dozens of analysts from large investment banks and brokerages analysing and modelling their financial performance. The more attention a stock or company receives, the far more likely it is that the market has priced it correctly and that all available information is accounted for in its price.

Outperformance in stocks is possible when analysts or portfolio managers are able to identify factors that the broader market has priced correctly. For larger companies that is going to be difficult when there are dozens of other highly skilled investors, trawling through all the available information and building highly detailed financial models.

ASX listed small-cap companies aren’t likely to be in that situation, with many companies receiving no coverage from these same professionals at all. This means that for those that are willing and able to put the time into fundamental research, the odds of finding information that the market might have missed is far greater. This could leave significant upside in place for those prepared to look.

When some of the underpriced companies do start to get attention, that can also lead to them becoming re-rated resulting in further price gains.

Diversification

As we’ve seen with small-cap companies on the Australian share market receiving far less attention, they are also less likely to move with the broader market.

At the same time, many will not be part of the major indexes and as such won’t be highly correlated to the movements in overall markets. They are also potentially less correlated to things like interest rates or even the gold price or price of iron ore, for commodity smallcap stocks.

That suggests that having exposure to small-cap stocks can potentially help not only diversify your portfolio but assist with reducing risk.

Access to management

As an analyst or portfolio manager, it is going to be very difficult to get direct access to the management of larger-cap companies, such as BHP.

On the contrary, small-cap companies are much more open to talking to inventors and analysts as they are happy to make the case for their business. This gives those willing, the ability to get insights and a better understanding of the business model for these companies.

Large investment universe

The ASX has more than 3000 companies currently listed, with the 50 top stocks taking up most of the attention of the media and analysts.

It’s worth noting that there is a huge universe of ASX small cap stocks to buy when building a portfolio and that allows for more opportunity to identify underpriced companies or companies with significant upside. This is important from an investment decision point of view.

Take over targets

Small emerging companies can make for excellent takeover targets, which can lead to large increases in their share price.

Takeovers of larger companies are also possible, however, it is much easier for a larger company with a similarly aligned business to look to boost its revenue through a strategic takeover with a small, upcoming company.

Small-Cap Risks

While there are significant benefits of investing in small-cap stocks, like anything, there are risks to consider. At the same time, it’s also worth looking at ways to mitigate those risks.

Liquidity

The smaller the company, generally speaking, means there will be less liquidity. Liquidity refers to the ability to buy and sell in and out of positions as required.

One way to assess the liquidity of a small-cap stock is to look at the daily volume as well as the order book. The more volume and the more orders, the better.

Liquidity risk can be further reduced, by investing in an Active ETF as a way to get that exposure to small-caps, without the need to worry about liquidity of a given company.

Wider Spreads

Similar to liquidity, some small-cap stocks tend to have wider spreads, meaning the difference (prices) between the bid and ask (buy and sell price) is wide. Like most ASX stocks, you are able to buy and sell shares with a limit order. During times of volatility, smaller-cap stocks have the possibility to widen further.

In reality, even large-cap stocks have issues with wide spreads and liquidity.

Fewer Revenue Streams

Given the stage of development for small-cap companies, many will likely have limited revenues streams. That could mean these companies have a single product or even a single client, putting them at risk if they lost that source of income as it could seriously damage their cash flows. The biotech sector would be a good example, where many small companies rely on a single product.

This type of risk is again overcome through diversification, which is a key to a financial product like our small cap active ETF, IMPQ.

Lower or no dividends

Many small-cap companies are in an early stage of business development and are looking to put money back into the company to power future growth. As a result, they are likely not going to pay substantial or any dividends and are not usually classified as dividend stocks.

Often times, the focus of small-cap investors is not to be trying to achieve capital growth instead of income. This is not a downside in as much as it is a consideration.

Looking to Invest in Small Caps?

eInvest is bringing active ETFs to market where active management makes sense. Our Future Impact Small Cap fund (IMPQ), uses both financial metrics and sustainability scores to determine which small-cap companies are most likely to grow and which ones to avoid. Since inception in May 2019, the Fund has delivered a +3.8% p.a. return net of fees, outperforming by +3.7% p.a. the benchmark return of +0.1% p.a.

So, to have a positive impact, both for your portfolio and society at large, consider IMPQ for your portfolio.

By Tamas Calderwood.

The Responsible Entity is Perennial Investment Management Limited ABN 13 108 747 637, AFSL: 275101. The Investment Manager is Perennial Value Management Limited ABN 22 090 879 904 AFSL: 247293. This promotional article has been prepared by ETF Investments Australia Pty Ltd trading as eInvest Australia (‘eInvest’) ABN: 88 618 802 912, as the corporate authorised representative of Perennial Investment Management Limited. This promotional article is for information purposes only. Accordingly, reliance should not be placed on this information as the basis for making an investment, financial or other decision. This information does not take into account your investment objectives, particular needs or financial situation. While every effort has been made to ensure the information is accurate; its accuracy, reliability or completeness is not guaranteed. Past performance is not a reliable indicator of future performance. You will be able to download the PDS from www.einvest.com.au