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Winning small caps

This article appeared in the July 2010 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Know the benefits - and risks - of investing in emerging companies.

Photo of Toni Case By Toni Case, TheBull.com.au

If you want to build wealth by investing in the sharemarket, small-cap companies should be part of your portfolio, depending on your risk tolerance.

Looking back to 2003, getting on board Fortescue Metals at 3 cents (now trading at $4.50) or JB Hi Fi at $2.10 (now a whopping $19.65) were golden opportunities.

Always remember that small-caps are generally riskier than blue-chip companies. Conservative long-term investors seeking dividend yield may be better off buying shares in established blue-chips, which should certainly dominate the share portfolio allocations of these investors.

But if you want to grow wealth faster, it is the small fry where big money can be made - and lost .

What is a 'small cap'?

In small caps, the market terminology for smaller companies, cap refers to market capitalisation, which is calculated by multiplying the number of shares outstanding with the current share price.

The S&P/ASX Small Ordinaries index measures the performance of small companies in Australia. The largest company in the index has market capitalisation of $1.91 billion, and the smallest $20 million. The average market capitalisation of companies in the index is $460 million.

Successful investing in small caps is about finding tomorrow's stars before the rest of the market catches on. Had you invested $10,000 in WorleyParsons shares at $1.70 in March 2003, you would have $130,000 worth today (they are currently trading at more than $22). A play on Telstra back then would be worth less today.

It is much more likely for a small company with annual sales of $10 million a year to double or triple earnings over a shorter time (if it wins a lucrative contract or expands into new markets) than it is for a large, mature company to boost earnings from $3 million to $6 billion a year. And because share prices reflect the future earnings of a company, the price of your favourite small cap can run quickly when there is a turn for the better.

Chance to beat institutional players

One of the pluses of investing in small companies is that it is one of the rare times you can beat institutional players at the game. The illiquidity of small companies means the majority of fund managers tend to stay clear (illiquidity makes it difficult for fund managers to buy enough shares). Therefore it is possible to get on board a winning small cap before institutional investors start throwing money at it, and push up the price.

Another related advantage of investing in smaller companies is that, with so little research undertaken by brokers and fund managers, these companies often trade at a discount to their valuation. In other words, many sell cheaply.
 
A number of studies have shown that small-cap returns often exceed large-cap returns.

Choosing a good time to buy small caps

Small-cap companies tend to outperform larger companies' shares in the first year of a bull market, according to Standard and Poor's. The second year of a bull market is also generally positive for small-cap returns. But by the third year, they outperform large-cap companies only about half the time.

The worst time to jump into the small-cap sector is at the tail end of a bull market, because as investors become more risk-averse they tend to ditch riskier small companies in favour of blue-chips.

The recent market correction is a case in point. The S&P/ASX Small Ordinaries index has taken a beating, declining by 10.38 per cent in the year to June 23, compared to minus 7.9 per cent for the S&P/ASX 200 index, which is made up of the largest 200 companies.

The problem with smaller companies is they are often in niche industries, sell a limited number of products, and hold more debt - making them more sensitive to rising interest rates. Management turnover, and the loss of key executives or contracts can also send their share price tumbling.

Choosing wisely before investing, and ongoing monitoring, is essential to avoid losing money on small-cap investments.

Key ingredients for a winning small cap

  • The shares have consistently outperformed the All Ordinaries index and the Small Ordinaries index
  • The company's earnings consistently exceed market expectations
  • The company has a strong brand name or dominates an industry or niche market
  • Brokers are lifting the company's earnings forecasts
  • The company generates a high return on equity (ROE)
  • It is priced below book value.

Look for the following telltale signs of a small cap that could be about to blow your funds:

  • It has consistently underperformed the All Ordinaries index and the Small Ordinaries index
  • The company posts earnings significantly below expectations
  • Analysts are lowering earnings estimates
  • Growth in earnings, revenues or profit margins has tumbled in several consecutive quarters
  • The company carries more debt than equity
  • Analysts rate the company a 'Sell'
  • The company is a market darling.

The best way to manage a small-cap portfolio is to mix it up with large caps, because the two sectors tend not to move in unison. Large caps outperform small caps in some years, and vice versa. Rather than attempting to forecast the next cycle, it is preferable to include a mix of winning small and large companies in your portfolio. That way, at every point in time, you are able to benefit from the next cyclical upswing.

About the author

Toni Case is the editor of TheBull.com.au, Australia's leading trading and investing site. Each week TheBull's free newsletter offers 18 share tips from more than a dozen leading brokers, tailored share portfolios for income and capital growth, plus investing, super and property strategies.

From ASX

Follow how small-cap companies are performing through the S&P/ASX Small Ordinaries index, which includes companies in the S&P/ASX 300 index but outside the S&P/ASX 100 index. Capitalisation indices provides useful information on a range of sharemarket indices. 


The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

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