The STRIDE Blog

Practical Investing: The Case for Small Caps

stride-practical-investing-the-case-for-small-caps-featured.jpgIt's no secret that small caps consistently outperform large caps worldwide. But does that make it practical investing? Does the higher risk of small cap investments offer a high enough reward for value investors to dive in?

I think so. I'm using this blog to investigate why, and I think you'll come out in agreement. For the beginner investors out there, let's start by looking into some definitions:

  • Market capitalisation: A company's market capitalisation is the market value of its outstanding shares.
  • Small cap stocks: The definition of small cap can vary among brokerages and investors, but it's generally a company with a market capitalisation of between $300 million and $2 billion.
  • Mid cap stocks: If a small cap stock has a market capitalisation of between $300 million and $2 billion, then a mid cap stock is generally defined as having a market capitalisation of  anything between $2 billion and $10 billion.
  • Large cap stocks: A large cap stock is generally defined as having a market capitlisation of $10 billion and upwards. But, as we said above, these definitions can vary between brokerage and investors.

The major difference between small, mid, and large cap stocks is the scope of their market capitalisation. But, while large cap stocks are attractive because their revenue and profit streams are far larger than small or mid caps, basing your stock pics solely off that fact is a tad short-sighted. One shouldn't ignore the wider benefits of investing in small cap stocks.  

With small caps, there is a risk and liquidity premium that we can't run away from... but this also means they present fantastic growth opportunities. It's an obvious point. To grow a business from $10 million to $100 million is much easier than growing one from $10 billion to $100 billion. Thus, small caps represents a much higher growth opportunity for value investors, which is the main driving force for investing in them. 

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Shares of small-capitalization companies have been busy beavers, besting larger-cap stocks since February after a long period of under-performance, with the Russell 2000 outscoring the S&P 500-stock index. And analysts point out that small-cap investing has proven to be the better play for the long term.

“It’s well documented that a dollar invested in small-cap stocks since 1925 would have returned $27,000, as compared to $5,000 from investing in the S&P 500-stock index,” says Nick Galluccio. - Gene Marcial, Forbes.com 

Why Small Caps are Well-Positioned for Value Investors

This massive growth potential points to more benefits for value investors when investing for long term results. Below, I've outlined three of the top reasons why small cap stocks are well positioned for value investors.

1. Small cap businesses are more agile

It's an obvious fact, but a powerful one. The smaller you are, the easier it is for you to maneavour through small spaces, and you can do so quicker.

"[...] size seems to make many organizations slow-thinking, resistant to change and smug." - Warren Buffett

That's a comforting thought when we see market fluctuations as wild as 2016's rollercoaster. Brexit, the US elections, Chinese and Russian trade deals have rocked the boat this year. We've seen stocks dipping, rising, and doing things we never might have imagined... but while small cap businesses are affected by this, their limited liabilities help to get them back in shape quicker than some of the large cap businesses. 

Then there's the fact that I see disruptive technologies changing the world. Businesses are needing to adapt or die, especially if you're not one of the businesses putting out the disruptive tech. In general, this is much more achievable for small cap businesses, because their infrastructure, workforce, and reach is small. If you've got a family of ten and a family of three preparing to move into a new town, who's likely to get there first? And who's likely to not have a screaming match on the way? That little family of three can pick up their things and turn a new direction much easier than any family of ten can. 

2. Small cap businesses are likely to be profitably acquired

Small businesses are more likely to be acquired for a big premium than larger businesses. That's because buyers will be paying for the high growth potential that a small business offers, not only its current physical value. We've written extensively on how to value a business, but the obvious point of this is that investors can benefit if their investment gets sold at a premium (as the stock price will likely increase impressively, based on the business's newly valued price). 

"Small-cap stocks are seen as having stronger growth potential simply because they are small companies," says Patrick O'Hare, chief market analyst at Briefing.com. 

In the three-month period that ended May 31, the Russell 2000 index, the benchmark for small-cap stocks, gained 11.7 percent versus the S&P 500 index, which increased 8.5 percent, O'Hare says. - Keith Brecht, USNews.com

3. Small cap businesses are often owner managed

No one wants to walk into a home where the children are running the household, and the parents live across the world. Yep, owner managed businesses are wonderful things for value investors. Warren Buffett himself is a fan of these kinds of small cap businesses, because they often perform better and have a high sense of accountability. Managers who think like owners or, better yet, are owners, can understand all the moving parts of a business. That means that they can oversee the vision as a whole, understanding what each role is intended for, and what the business needs from each employee, partner and venture. 

It is a real pleasure to work with managers who enjoy coming to work each morning and, once there, instinctively and unerringly think like owners. - Warren Buffett

Small cap stocks may fly under the radar, as analysts don't pay them much attention until they 'spike' up, but that's their beauty. In a world where yields are dropping along with economic growth, finding well-run small businesses gives you a distinct advantage. The key is simply in picking the right small businesses.

STRIDE's stock screening and stock picking tools make it easy to analyse which small cap stocks are right for you. If you'd like to see how this can work for you, sign up for your free STRIDE demo below. 

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Topics: Valuation, Commentary

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