Investing in small-cap stocks
29 May 2014
Equities are back in favour and investors are hunting for big winners. Small-cap stocks provide an opportunity for stock market investors to hunt out hidden gems overlooked by larger investors.
Companies listed on stock exchanges are categorised by their size, or market capitalisation, or ‘market cap’. Market cap is determined by the number of shares on issue multiplied by their price. So a company with 10 million shares trading at $5 would have a market capitalisation of $50 million. Market caps move around with the share price; as companies grow their market cap increases, and vice versa.
There are various definitions of small-cap stocks. But generally large-cap or blue-chip stocks are the largest 100 stocks by market capitalisation; the next 200 are mid-cap stocks and those outside the top 300 are small-cap. Some fund managers, however, can define small caps as anything outside the top 100. While most stocks outside the top 100 have market caps of less than $300 million, based on the fund manager definition, some small caps are quite substantial, with market caps greater than one billion dollars.
The ASX has two small-cap indices. The S&P/ASX Small Ordinaries Index is comprised of companies included in the S&P/ASX 300 index, but not in the S&P/ASX 100 index. The S&P Emerging Companies Index represents the performance of companies ranked outside the S&P/ASX 300 by capitalisation.
Volatility
Small caps have traditionally been outperformed by their larger peers, but times have been tough recently with steep losses in the past year.
The Emerging Companies Index has slumped 16.74 per cent in the last year; the Small Ords is down 6.74 per cent. Meanwhile, the S&P/ASX100 is up 12.31 per cent.
Adrian Atkins, Senior Equities Analyst at Morningstar Australia says during and after the GFC, small-cap stocks generated poorer returns and were more volatile than larger stocks. “You got the worst of both worlds,” he says. “That won’t always hold true. Over the long term you should get higher returns and higher volatility.”
Over the past five years, the S&P/ASX100 has outperformed with an annual return of 8.41 per cent, against 5.24 per cent for the Small Ords and 6.22 per cent for emerging stocks.
Risks
Experts warn that while big gains can be on offer, smaller companies have significant risks which means retirees should be wary of putting too much money in them. Atkins says conventional wisdom is that small-cap stocks outperform bigger companies over the long run, but are more risky. “Just as there might be hidden gems, there might be hidden landmines,” Atkins says.
Academic research has found a small-cap premium for investors over the long term.
But there are risks to investing in small caps. Michael Kemp, Chief Analyst at the Barefoot Blueprint, notes that small caps are less liquid: they don’t trade as often and they trade in smaller volume. That makes it hard to get in and out of stocks when you want to, particularly after bad news.
Kemp says small-cap stocks also tend to be ‘one product’ companies. Many are start-up companies with short track records; they’re often unprofitable and are spending rather than making cash, meaning less cash for dividend payments.
The research
Atkins says that when looking to invest in small cap-stocks, if you’re not relying on professional research you need to be careful. “You have to know the business well,” he says, adding that investors need to be particularly careful about untested speculative stocks.
“You’re taking a guess about what the blue sky potential is,” Atkins notes. “You wouldn’t want to bet the house on it. You’ve got to know the risk profile of the stock you’re investing in.”
Atkins says for retirees, small caps can form part of a diversified portfolio. He says that stocks like BWP Trust, a small-cap stock that owns the warehouses Bunnings operates in, are just as safe as larger property trusts.
Kemp, however, says that he doesn’t believe small caps have a specific role in a retiree’s portfolio: a stock should be added to a portfolio if they are a good stock to buy, whether big or small.
“When I select stocks I throw them all into the same sieve,” he says. “I believe that the same fundamental rules governing ownership of a stock apply to small caps as to large. Good cashflow, low debt level, high and maintainable return on equity, good long-term prospects for the underlying business. There's nothing amongst these selection criterion that distinguishes small from large.”
But for adventurous retirees who want to allocate a small portion of their portfolio to riskier investments, small caps can pay off. “Small caps fly under the radar of the big fund managers,” Kemp says. “That might make for more fertile hunting grounds.”
Ones to watch
For retirees looking at small caps in 2014, Adrian Atkins says the market is difficult. Good ‘industrial’ small caps have rallied hard recently. “If you’re going to invest in those good companies you’re going to be paying a high price,” he says.
By contrast, resource stocks are looking cheap, but Atkins says many are not investment grade and they could end up destroying shareholder value.
So Atkins says he prefers safe small caps that investors have turned their backs on, such as BWP Trust, which owns Bunnings Warehouses leased to the Bunnings Group. BWP has a 7 per cent yield and better-than-inflation growth rates.
“That should be appealing given what’s happened with bank deposit rates over the last couple of years,” he says.
Atkins also likes Qube, a vertically integrated logistics company chaired by former Managing Director of Patrick Corporation, Chris Corrigan. “We think it will generate strong growth over the long term,” Atkins says. “Its stock is currently a bit pricey, but we’d recommend buying dips.”
Morningstar also has positive recommendations on higher-risk small caps, including Western Areas, which has a nickel mine in the Forrestania belt 400km east of Perth, and SAI Global, which has an exclusive license to publish and distribute Australian Standards.
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