Small caps stocks – companies with a small market capitalisation – can present tremendous opportunities to the savvy investor who can determine a fast grower at a reasonable price. But with this comes a particular set of risks that should be taken into account by all who invest in them. Here are 4 things to consider before investing in small cap stocks.
(The definition of a small market cap will vary between investors, but I’ll assume it refers to a company worth less than $100m in market capitalisation. Conversely, I’ll assume a large market cap refers to a company worth more than $1b.)
Liquidity can be poor
Companies with a large market capitalisation have excellent liquidity because there are millions (sometime billions) of shares available to be traded in the market. This provides an opportunity for many thousands of shareholders to own shares because the proverbial pie is so big. When many thousands of people own a company, the chances of many people wishing to trade any given time is high. With more buyers and sellers there is more competition for trades and therefore there is more likelihood of an efficient market. That is, the market price actually reflecting the underlying value of the business.
The case is not the same for small cap companies, as they have much fewer shares to go around (in terms of value and volume). Further, the founders and management may also hold a more sizeable proportion of the company, reducing what’s called the free float – the number of shares available to be traded on the market (since it is assumed that management are less likely to sell down).
The reason low liquidity can be a risk is because it reduces the ability for the market to price efficiently, since there are fewer people willing to (or in a position to) trade. The “spread” between the buyers and sellers will be wider, which can lead to significant short term swings in the share price.
For example if you wanted to sell some shares in Kip McGrath Education Centres (ASX:KME), you will note the best price offered by the buyers is 26 cents. However, the lowest ask price from the sellers is 34 cents, a spread of 30%!
You are heavily reliant on management’s expertiseThe important thing to remember is that this may not reflect the actual performance of the company. Check company reports and announcements to see if these buyers and sellers are being rational or not.
Quite often, the management of a small cap includes the founder, or at least people who have helped build the company from the ground up. They therefore have intimate knowledge of how best the company should be run.
Management will often have great ownership (both emotionally and physically in shares) of the company and therefore have a greater vested interest in its success, as their interests are closely aligned with the rest of the shareholders.
This actually contrasts with the sentiments expressed by investing great Peter Lynch in his book One Up on Wall Street, where he says:
“’Any idiot can run this business’ is one characteristic of the perfect company, the kind of stock I dream about.”
Lynch goes on to say:
“If it’s a choice between owning stock in a fine company with excellent management in a highly competitive and complex industry, or a humdrum company with mediocre management in a simpleminded industry with no competition, I’d take the latter”.
While this might be true for large companies who have had years of growth, market consolidation and building a competitive advantage, for a small cap company, a decision that costs the business a few million dollars is significant and could wipe out a year’s profit, whereas this will make less of an impact to a large, established business in the ASX200.
Capital raisings may be frequent to fund their expansion
High growth small caps are often in a land grab situation, meaning it is a race to establish customers before your competitors do. If cash flow is not sufficient enough to fund such a rapid expansion, the company may need to raise capital from the market.
If the company does this intelligently and in a way that creates value for shareholders, then we don’t have a problem. But when shareholdings are diluted from consistent capital raisings and earnings aren’t growing by a congruent amount, then it is time to find a new company to invest in.
Small caps can make or break your portfolio
When small caps grow, they grow big because they are growing from a low base. However, when they fall they can also fall big, especially if they are in the high growth phase and are trading on a high P/E. This could have a material impact on your portfolio either way if the company represents a significant portion of the portfolio.
Additionally, if a company has a particularly negative update, investor confidence could be shattered, which could lead to a large depreciation in the share price and could take some time to recover as confidence is restored.
The simple idea with small caps is that they are higher risk, but represent a higher reward due to higher level of growth they could potentially achieve.
A lot of money can be made in small caps because – if you find the right one – they are growing strongly and doing so off a small base, which has the effect of amplifying gains in contrast to large companies. All of these factors listed above don’t necessarily mean you should avoid small caps, but small caps do present a unique set of risks that must be taken into account before investment.
To discuss with someone about investing in our small cap portfolio, the Farnam Equity Value Portfolio, click here.
Note: Farnam owns shares in Kip McGrath Education Centres Limited in the Farnam Equity Value Portfolio.
This document has been prepared by Farnam Investment Management Pty Ltd (Farnam) ABN 15 149 971 808 AFS Licence 430574. While every care has been taken in the preparation of this document it does not contain any recommendations to buy or sell any particular stock(s) noted. Farnam makes no representation or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. The information in this document is general information only and is not based on the financial objectives, situation and needs of any particular investor. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. Past performance is not a reliable indicator of future performance. The information provided in the document is current as the time of publication.