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Small-cap risks explained

This article appeared in the March 2013 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.

Capitalisation is ever changing, along with equity value.

Photo of Michael Kemp By Michael Kemp, Barefoot Blueprint

Investment books have long stated that, over time, diversified portfolios of small stocks deliver index-beating returns. They even tell us why. It's the classic academic trade-off between risk and return. Investing in smaller companies is considered more risky, and it's argued that the higher returns they deliver compensate investors for taking on more risk.

Empirical studies backing up this superior return argument do exist. But be careful. For a start, the studies are largely US-based and we need to know if they apply to our market.

Second, it's dangerous to apply rules to the sharemarket because most are quite fallible.

And finally there is that classic human frailty. Once stated, things can become accepted as dogma even when subsequent events fail to back them up.

So does investing in smaller companies deliver better returns and does it involve taking on more risk?

Market capitalisation

First, let's look at how company size is defined by the market. Investors use a metric referred to as market capitalisation, which is calculated by multiplying the number of shares on issue by the current market price of one share.

For example, if a company has 30 million shares outstanding, each with a market price of $5, the company's market capitalisation is $150 million (30,000,000 x $5 per share).

It sounds easy but it's important to appreciate the following:

  • Market capitalisation is an ever-changing number - it changes as often as the share price.
  • It is influenced by the market's perception of value, so includes all those factors causing stocks to be mispriced. That is everything from unfounded rumours to raging bull markets.
  • Strictly speaking, market capitalisation is neither a measure of a company's size nor its total value. A company's operations are typically financed by a mix of equity and debt; that is, both money contributed by shareholders and borrowed by the company.
  • But market capitalisation measures value only from the shareholder's perspective (that is equity only). It does not value that part of the company financed by debt. An example: if you own a house worth $800,000 with a $300,000 mortgage, what is the house worth? Clearly it's $800,000. But your equity is only $500,000 ($800,000 minus $300,000). The $500,000 is analogous to market capitalisation. Which means unless a company is 100 per cent equity funded; market capitalisation tends to undervalue the enterprise.

From Nano to Mega

The term market capitalisation is usually abbreviated to market cap, and market caps are often grouped by size. In order of increasing size, we have nano-cap, micro-cap, small-cap, mid-cap, large-cap and, in the US, mega-cap stocks.

These groupings are not determined by fixed dollar amounts or ranges. In fact, the dollar value of companies in each group varies between markets around the world. A company described as large-cap in Australia (outside the top 20) might only qualify as a mid-cap in the US.

It is more appropriate to think in terms of percentiles of size rather than nominal dollars when considering where to pigeon-hole companies.

Finding small-cap stocks

Your search for small-cap stocks should start with the S&P/ASX Small Ordinaries Index. It is comprised of companies included in the S&P/ASX 300 index, but not in the S&P/ASX 100 index. (Editor's note: ASX Capitalisation Indices is a good place to start, to get more information on key sharemarket indices).

For a full list of the companies making up the index go to your preferred broker's website, type in the ASX code XSO, and click on the appropriate tag. The market caps of most of the companies in this index are in the $100 million to $1 billion range.

If you want to go even smaller then look at the S&P/ASX Emerging Companies Index (code: XEC). It includes micro-cap stocks listed on ASX. It has a maximum quota of 200 securities that are selected based on aggregate total market-capitalisation and liquidity criteria. Currently there are 143 constituent companies ranging in size from $14 to $385 million, with an average size of $125 million.

Benefits of investing in smaller-cap stocks

Fishing in the smaller end of the market means:

  • Less competition. Because the big fund managers have large amounts of cash to invest, small companies are less likely to fit their liquidity and size requirements. They will be spending more time looking elsewhere.
  • With fewer professional investors hunting in this market, there is more potential for market mispricing. That is, a discrepancy between the market price of a stock and its true worth (intrinsic value). This pricing inefficiency can provide more opportunity for the astute stock-picker.

Risks of investing in smaller-cap stocks

The potential downsides are:

  • Smaller-cap stocks are less liquid; they trade less often and in smaller volume, which is not so good if you are trying to get out of a losing position in a hurry. Poor liquidity can also result in wider bid/ask spreads. In other words, a higher cost to get in and out of a stock.
  • Short sellers tend to be attracted to smaller-cap stocks. These players profit from selling a stock and then buying back their position after (hopefully) a price fall. Less trading volume means the market price is more responsive to buying and selling pressure.
  • Small-cap stocks are more likely to be one-product companies. This is by no means a golden rule but where it does apply it can present a potential risk. Risk increases when a company is operating in an area of rapid technological change.
  • Smaller-cap stocks are more likely to include start-up companies or companies with a short track record. This has implications for cash flow. Start-ups tend to be cash burners rather than cash generators. This usually means less cash for dividends.

These risks can be reduced by holding a diversified portfolio of small-cap stocks rather than just one or a few companies.

Do small-cap stocks deliver higher returns?

The following exercise is a bit of fun if you have access to charting tools allowing the direct comparison of ASX indices

I compared historical returns between a broad index (the All Ordinaries Index) and the Emerging Companies Index and the Small Ordinaries Index. This is what I discovered in terms of price change alone:

The S&P/ASX Small Ordinaries Index has underperformed the All Ords over the past three, five and 10 years.

The S&P/ASX Emerging Companies Index (micro-caps) has significantly underperformed the All Ordinaries Index over the past one and three years. Since its inception in August 2009 it has fallen by around 10 per cent. Over the same period the All Ords has risen by 15 per cent

I admit I didn't look at their respective accumulation indices. But I suspect the picture for the small-caps would have still been negative. But remember, this conclusion is based on indices, each of which includes many companies, both good and bad. Perhaps skilled stock-pickers can still look upon it as fertile ground for finding individual stocks.

About the author

Michael Kemp is chief analyst at The Barefoot Blueprint.

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