The 6 reasons small caps can supercharge your investment returns

Small cap stocks can increase your portfolio returns, but they’re also more risky investments than large caps. In this post I’ll outline the six key advantages of investing in small caps versus bigger companies, and I’ll also point out some of the extra risks.

Advantage #1: Smaller companies are less well researched

An army of analysts, brokers, traders and journalists pours over every share listed on the major stock markets. Each individual is looking for an insight that others have missed such as:

• Increasing earnings (perhaps hidden by unusual expenditure)
• An overlooked new product
• The arrival or departure of a key executive
• Undervalued assets on the balance sheet (particularly property)
• Legal developments
• Too much cash being spent on the corporate washrooms
• One of a million other things

A useful nugget might be revealed in an interview in the trade press or be buried in the small print of the company’s final results. Anything material must be declared to the market, but a lot of investing comes down to judgement. If you understand the ramifications of a piece of information better or more quickly than others, you still have an edge over them.

The key point regarding small caps is these professional analysts overwhelmingly concentrate on larger companies.

Analysts have to pay their bills, too. And they’re much more likely to sell their research to fund managers looking to put millions into a major oil share. Brokers concentrate on bigger companies, too, since they need commission from institutions who deal in volume. And institutional traders aren’t likely to pursue micro-stocks worth less than the value of their own house.

These analysts all cover Apple (AAPL), the tech giant:

Actual, American Technology Research, Argus Research, Atlantic Equities, Bank of America Securities, Barclays Capital, Bernstein Research, BMO Capital Markets US, Citigroup Investment Research, Credit Suisse, Deutsche Bank Research, FTN Midwest Securities, Gabelli & Company, Goldman Sachs, JP Morgan, Kaufman Bros, Kintisheff Research, Morgan Keegan, Morgan Stanley, Needham, Oppenheimer & Co. Inc., Pacific Crest, Piper Jaffray, RBC Capital Markets, Standard & Poors, ThinkPanmure, Thomas Weisel Partners

These cover Psion (PON), the UK-listed technology small-cap:

ABN AMRO, Panmure Gordon, Seymour Pierce, Teathers Limited

With which share are you more likely to spot something others have overlooked?

Advantage #2: It’s easier to double the sales of a smaller company

• A small fast food chain can roll its format out to more cities or countries
• A small manufacturer can devise a breakthrough product that becomes a global smash, quadrupling its sales
• A one-magazine publisher can start a second magazine

It’s far harder to double the $10,000 million turnover of Starbucks (SBUX) than the $100 million turnover of London-listed Carluccio’s (CARL). Not impossible – giant companies become giants, after all. But by definition only a few big companies will become giants, whereas a lot of successful young companies can and do grow fast.

‘Elephants don’t gallop’ is how investment legend Jim Slater put it. He prefers sprightly small caps to elephants.

Advantage #3: Small caps often get re-rated

Quick reminder: The price-to-earnings (P/E) ratio is a measure of how highly rated a stock is. If the market believes earnings are going to rise a lot in years to come, it will pay more for shares in that company now, compared to a plodder going nowhere. In other words, the P/E ratio will be higher for the fast-grower.

Generally, small caps trade on lower P/E ratios than larger companies, at least until their ‘story’ becomes widely appreciated. Not always: tech start-ups soared in the dotcom bubble on stratospheric P/E ratios, and big companies can fall out of favour and see their P/E drop. But usually smaller companies are on lower ratings, perhaps because they’re riskier.

In hunting for small cap growth shares, you want to find an exciting company that’s either new or that has a new story, but which hasn’t been fully noticed by other investors yet. (If everyone believes the company is going to keeping growing at 20% a year, the P/E ration will have already been bid up, and will be vulnerable to a de-rating if they disappoint.)

Jim Slater explains the power of P/E re-rating very well in The Zulu Principle.

You see something special in a small cap company when it is still relatively unknown. This company is lumped in with the other small caps in its sector, on a P/E of say 10. As it outperforms and more people are convinced its earnings growth is sustainable, its P/E ratio could increase to say 20.

This re-rating has a dramatic effect on your returns, compared to if the company simply grew its earnings but wasn’t re-rated:

Let’s suppose the re-rating occurs as earnings are growing at 25% a year and are forecast to keep doing so.

The combined effect of the change in earnings and the higher multiple increases your gain from 25% to 150%, like so:

(100 + 25) x (20/10) = 250
Original investment = 100
Gain = 150%

This dramatic return is what attracts private investors to fast-growing companies.

Be warned, finding consistent growth shares is not half as easy as it sounds. Over the long-term, value investing has a better track record. But the market continually offers up growth company opportunities to those few who can spot them.

Advantage #4: Your knowledge can give you an edge

You’re not going to be the first investor to notice McDonald’s burgers are better than they were. Millions eat at McDonalds (MCD) every day.

but you could be first to spot bigger queues at the Gourmet Burger Kitchens run by Clapham House (CPH).

Expert or local knowledge is more likely to be worth something when evaluating small caps. Your mum might say her new indigestion pills are amazing, but the Big Pharma company that makes the pills already produced research telling analysts that months ago. Your insight was right, but it’s too well-known to be valuable.

• Whether this sort of information can be really be ‘new’ in an efficient market is a hotly debated topic. I don’t think the market is always efficient.

• If you think the market is truly efficient, you should only invest in index trackers, rather than individual shares, whether small cap or large cap. You’ll probably do better than active investors, though we’ll have more fun! (I cover both styles of investing on Monevator, so please do subscribe).

• If you think the market is somewhat efficient, it’s clear smaller companies offer a lot more opportunity for private investors to spot the information the market has missed

Advantage #5: You can buy small caps, ‘they’ can’t (so be glad you’re not a billionaire)

Some funds are dedicated to small caps, but the majority invest in larger companies.

Imagine you manage a giant pension fund. It’s hardly worth you glancing at the share price of a small cap, because:

• You won’t be able to invest sufficient money into a small company without moving the share price.
• Investing across hundreds of companies, you’re not going to be able to keep track of the activities of small caps unless you’re the next Peter Lynch.
• If you do manage to invest a significant proportion of your millions under management into a small cap, you’ll probably have to declare it publicly. Everyone will then know what you’re buying, and bid up the price (fine if you’ve finished buying, but bad if you’re still building a position).
• Even if the share price doubles, a small investment will barely impact a massive fund’s returns.
• Your mandate might bar you from investing in small companies anyway.

Compare that to the portfolios of us private investors:

• We can invest a significant portion of our wealth into even a micro-cap without moving the price much.
• We can put our money into as few companies as we choose.
• We will notice a doubling or tripling of the share price in a ten stock portfolio. (Oh boy, will we notice!)

Advantage #6: Small cap indices have historically produced greater returns than large caps

The advantages we’ve looked at apply to picking individual small cap stocks over large caps. But a broad basket of small cap shares has historically done better than large caps, too, especially when you add value versus growth to the mix:

Exactly why this situation should persist is an old puzzle, but a New York Times article on the small cap advantage proposes an answer:

By definition, an overvalued stock has a larger market capitalization than would otherwise be the case. Its price-to-book ratio is also higher, and thus it is closer to the growth end of the growth-value spectrum. Portfolios of large growth stocks will contain a disproportionate number of overvalued issues, and should, on average, lag behind the market.

The opposite is the case for undervalued stocks. So small-cap value portfolios will have more than their share of them and should beat the market in the long term.

We’re not looking specifically at value versus growth here, which does juice the returns further. The take away for now is that if you invest in a basket of small caps, history suggests you’ll have a good following wind with you.

Remember: Small caps investing is more risky

Small caps offer advantages, but there’s good reasons why even private investors often favor bigger companies:

• Small caps are more volatile (at both the individual and index level)
• Small caps go bust (or near as damn it) much more often
• The spread between buying and selling prices can be large, so your new investment shows a sizeable immediate loss
• They’re much less liquid – if bad news hits the company, you may not be able to sell your holding quickly, or only at a very low price
• They’re arguably more prone to hype and investment mania
• Small caps are often more closely correlated with the domestic economy

So is it sensible to invest in small caps?

The evidence says investors should drip money into index trackers over the long-term. You’ll get the average market return that way, and you won’t pay all the fees associated with buying and selling individual shares, let alone over-trade and do worse.

One middle-way solution is to invest say 10% of your portfolio in a small cap fund, to get some benefit of the broader small cap gains we considered earlier without taking on too much volatility. Several small cap index trackers and ETFs track the North American market. UK investors aren’t so lucky, and are best off looking at cheap investment trusts with decent long-term records, such as Aberforth Smaller Companies and the Rights and Issues Trust. Avoid expensive small-cap funds with up-front charges!

But suppose you decide to invest some portion of your worldly wealth into individual stocks, rather sensibly buying the market via index trackers. Perhaps like me you enjoy the challenge. You find investigating companies interesting, and you’re prepared to risk doing worse than a passive investor for the possibility of doing gloriously better.

In that case, I believe investing in small caps versus large caps has advantages we just can’t afford to ignore in seeking an investing edge.