The Heaviest Small–Cap Discounts in 20 Years

In today’s Money Morning…from small-cap to household name…the unique advantage you have over the big investment firms…a deeply discounted market that could be ready to soar…and more…

I’ve been investing and trading in small-caps ever since JB Hi-fi [ASX:JBH] floated on the Australian stock exchange in 2003.

‘Wait a minute,’ you say, ‘JB Hi-fi isn’t a small cap stock.’

No, not now it’s not. But it was back then.

Today it’s a $2.9 billion blue chip company. It’s part of the ASX100, the index of Australia’s top 100 most valuable companies. Yesterday it made record profits.

But when it listed in October 2003, JB Hi-fi was worth $184 million. It was a relatively small company.

Since then, it’s gone on to increase its valuation by 1,576% (plus dividends paid to shareholders every year).

And that’s why I, and a lot of people like me, are attracted to investing in this end of the market.

There’s nothing better than the thrill of discovering and investing in a game-changing stock with big potential. One that grows profits and shareholder returns fast.

But small-cap stocks can seem very risky. And they are very risky…if you don’t know what you’re doing.

To invest in growth stocks, you really have to learn all aspects of investing. From fundamentals to technical analysis. From psychology to business strategy.

It’s certainly not easy.

But there are a number of factors that give ordinary investors a unique advantage to profit in this sector.

I’ll come back to your advantage over the big fund managers shortly.

But first, let me explain why I’m writing about this today. Because right now, the market is discounting these small-cap opportunities at a deeper level than ever before.

Consider this 20 year chart of the Australian market:

Source: Incredible Charts
[Click to enlarge]

It shows the total index (blue line) versus the index of all companies except the top 100 (green line) by valuation.

You can see that the top 100 companies’ index broadly leads the small companies’ index. There are times, especially in boom times (2003–07) when the small company index rises at a faster rate and catches up.

But usually they moved in tandem. Until 2011, that is.

Since 2011 the small-cap index has stayed level while the total index has increased. This is completely due to the rising valuations of the top 100 companies.

Small-caps are standing still, in comparison.

The gap in valuations between large and small companies has never been this large.

Is this an overlooked opportunity?

I think it very well could be…

Good things come in small packages

Sometimes it’s good to be small.

As the funds management industry has been discovering recently.

Large-cap fund managers have been investing in smaller companies the last few years because their traditional holdings were looking a bit soggy,

This earnings season we’ve probably seen a bit of a reversal of that trend, especially as those managers realise the rewards lie for those who are picking the correct stocks.’

That was Victor Gomes, portfolio manager of the UBS small-cap fund.

The problem for fund managers is that when they all want to exit (or enter) a stock at the same time, they find they have too much money and can’t get in or out without affecting the price dramatically. At least not at any kind of speed.

This makes small stocks a riskier investing opportunity for them.

And that’s why a lot of them have given up on investing in small-caps for the time being.

A small investor on the other hand can usually get in and out of a small-cap stock fairly quickly.

The ability to be nimble is a crucial advantage. You can let winners run, and get out of losers relatively unscathed.

Who owns the future?

This historical small-cap discount might be reflecting the general fear out there at the moment.

A lot of people are still expecting some kind of imminent market crash, and small-caps are hit hardest when the markets panic.

That’s something to bear in mind.

But if you’re a longer term investor and you are willing to ignore short term market noise, there are some compelling opportunities to look into.

We are living in the age of disruption after all. New inventions and new ways of doing business. This disruption doesn’t just grow small companies. It also can affect the valuations of big companies.

For example, what will the effect of the Uber Eats delivery service be on Domino’s Pizza [ASX:DMP]? Will blockchain technology and the cryptocurrencies built from it change banking as we know it? How will renewables affect oil companies’ earnings into the future?

These are big questions for investors. And a lot of the answers are coming from the small-cap space.

10 years from now a few of these small-caps might have grown into large caps. Just like JB Hi-fi did.

And with those kind of returns on offer, you only need a few of them to create strong long term wealth. If you find the right ones, of course!

Good investing,

Ryan Dinse,
Editor, Money Morning

Ryan Dinse is an Editor at Money Morning.

He has worked in finance and investing for the past two decades as a financial planner, senior credit analyst, equity trader and fintech entrepreneur.

With an academic background in economics, he believes that the key to making good investments is investing appropriately at each stage of the economic cycle.

Different market conditions provide different opportunities. Ryan combines fundamental, technical and economic analysis with the goal of making sure you are in the right investments at the right time.

Ryan's premium publications include:

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