Pros and Cons of Small-Cap Stock Investing

The Australian Stock Exchange can be a great place to find small-cap stocks if you know where and how to look.

After all, of the roughly 2,000 companies listed on the ASX, more than 70% are below $200 million in market capitalisation.

And 867 of these 1,400 small-cap stocks have a market cap below $50 million.

So the ASX doesn’t lack for small-cap opportunities.

The trick, however, is discovering small-cap stocks BEFORE they hit the big time. Before the wider market catches on. Before the institutional players roll in.

That’s when you could stand to make significant gains.

Take, for instance, Vulcan Energy Resources Ltd [ASX:VUL].

The lithium stock was trading for 55 cents in August 2020. Fast-forward to August 2021, and VUL shares are up more than 2,200%.

Or consider Archer Materials Ltd [ASX:AXE].

At the start of 2020, the developing technology company was trading for 15 cents per share. In August 2021, AXE was up 1,000%.

And there are other small-cap stocks out there on the ASX with great potential.

But why small-caps?

As the name suggests, small-caps are generally early-stage, emerging businesses. So small-caps can have more growth opportunities ahead.

And since small-caps are so numerous and frequently do not attract any analyst coverage, these companies with potentially large growth prospects operate in an environment where it is possible to get in before the wider market rerates the stock and sends its share price higher.

And while the elevated volatility of the small-cap space fills many with dread — for it means the stock can fall just as rapidly — this very volatility can be a boon.

With large price fluctuations comes buying opportunities that are less common with more efficient large-caps.

Now, despite the opportunities, the small-cap market isn’t an easy one to navigate.

There are more stocks to sift through. There’s less analyst and news coverage to fall back on. And there’s more risk.

Sometimes in these situations it may be difficult to know where to start.

Here at Fat Tail Investment Research, we have a small-caps advisory service run by market analysts Murray Dawes and Ryan Clarkson-Ledward. It’s called Australian Small-Cap Investigator.

Murray and Ryan dedicate their time hunting the most exciting, inspirational, and optimistic stock stories on the ASX right now.

Their advisory, for example, picked Afterpay before it was an Australian Financial Review mainstay.

Of course, they research stocks that are small, underreported, and risky.

But the small-caps profiled by Australian Small-Cap Investigator are also marked by a disruptive potential that makes them unmissable.

If you’re interested in getting more info on their service, you can read more here.

Of course, small-cap stocks also come with risks.

After all, the greater the potential returns, the greater the assumed risk. And small-cap investors must always take this into account and act accordingly.

If you’re looking to invest in small-caps, read on to find out the pros and cons of small-cap stock investing, why you should consider small-caps, and if they’re right for you.

What is a small-cap stock?

stock market graph

Small-cap stocks are companies that sit outside of the largest 100 stocks on the ASX by market capitalisation.

The S&P/ASX Small Ordinaries Index, for instance, represents the smaller constituents of the S&P/ASX 300 Index. It is this index that is used as a benchmark for Australian small-cap stocks.

Companies in this index generally have a market cap of $100 million to $2 billion.

Are small-cap stocks a good investment?

The higher underlying risk and volatility of small-caps can also mean small-caps can yield higher returns to compensate investors for incurring greater risk.

In other words, smaller companies have the potential to generate excess returns.

Why? In a company’s lifecycle, the point where revenue and earnings are expanding the fastest is often when the company is an emerging small- or mid-cap stock. It is often here that the stock’s share price also makes the largest leaps.

Small-cap stock returns can vary greatly from year to year. But small-cap stocks typically have higher returns than large-cap shares, so they may provide better long-term growth potential for investors willing to take on more risk.

According to research from ETF manager BetaShares, over the two decades to 2021, there have been five bear markets (defined as a market drop of more than 20%).

On each occasion, small-caps outperformed large-caps by an average of 14% over the six months following the end of the bear market.

Are small-cap funds a good investment?

Because the small-cap sector contains hundreds of underreported stocks, some individual investors may feel they do not have the time, skill, or information to directly invest in the sector on their own.

These investors may then choose to invest in small-cap managed funds, where their money will be pooled and managed on their behalf by professional managers.

Small-cap funds remove the decision-making about the investment from the individual. By choosing a small-cap fund, investors hope to access the expertise and systems of full-time professional managers.

But just because finance professionals run the small-cap fund doesn’t mean the risk inherent in the sector is eliminated.

Further, investors should note that funds will charge fees and fund redemptions may be slower than direct investments.

All up, investors should research the fund’s track record and strategy, deciding whether the benefits of going with a managed investment option outweigh the associated fees and possible inconvenience.

Where do I find small-cap stocks?

coins and ASX stock market graph

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A great place to start your search for hidden gems is by regularly checking out the ASX website and sifting through the daily ASX announcements and seeing which companies grab your attention.

You can also use stock screeners to filter stocks by market capitalisation and sort stocks by size.

You can also use the ASX website to monitor upcoming floats and IPOs, and assess the worthiness of businesses set to float on the exchange.

But the most important tool in finding stocks — small- or large-cap — is sound research.

The more you understand exactly what you’re investing in, the better-informed your investment decisions will be.

It’s also one of the most important distinctions between stock pickers and regular investors. A thorough investigation of a stock is how you get to the heart of the company.

As mentioned earlier, here at Fat Tail Investment Research, we have our own flagship small-cap investing newsletter, the Australian Small-Cap Investigator.

Run by dedicated analysts Murray Dawes and Ryan Clarkson-Ledward, Australian Small-Cap Investigator is Fat Tail’s longest running advisory and owes its longevity to a simple remit: find and recommend the tiny hidden gems trading on the ASX before the wider market catches on.

How much do small-cap stocks return on average?

Given there are hundreds of small-cap stocks on the ASX — spread across many industries and business cycles — finding the average return of a representative small-cap would not be very illuminating.

We can, however, assess the performance of the small-cap sector as a whole via indices.

For instance, the MSCI Australia Small Cap Index — designed to measure the performance of the small-cap segment of the Australian market — gained 212% between September 2006 and September 2021.

The MSCI Small Cap Index had a 10-year annualised return of 9.70%.

However, the MSCI Australia Index — designed to measure the performance of the large- and mid-cap segments of the Australian market — gained 259% over the same period.

How come it performed better? Isn’t the risk meant to grant small-caps better returns?

As asset management firm Schroders pointed out in a research note, Australian market indices are peculiar. Indices were set up to reflect the needs of the local capital markets, specifically for small companies to raise capital.

As Schroders wrote:

The nature of the local market meant that many of these companies were non-revenue generating mining companies who would raise capital for the purpose of exploration or mine development — and in the absence of a venture capital industry this capital was sought through the listed company stock exchange. So unlike many other markets, the Australian market indices were built around, at times, a large number of non-revenue or profit generating companies.

For reference, while the MSCI Australia Index gained 259% between September 2006 and September 2021, the MSCI World Small Cap Index gained 365% in the same period.

What type of small-cap shares should I buy?

There are hundreds of small-caps all scattered across many industries.

There are small-caps in the healthcare sector. There are small-caps in the fintech sector. There are small-caps in the technology sector.

Deciding what type of small-cap stocks to buy means being aware of the business sector a small-cap operates in.

Is the industry growing or flagging? Does it have high barriers to entry? Is the industry competitive?

That said, the success of a stock doesn’t rest solely on the prospects of its industry. Some firms fail even in booming sectors.

You must also research the fundamentals of the stock itself and pick small-caps with a sound business model and growth potential.

Is there a clear path to profitability? Can revenues grow? Can the company expand its market share?

These are all good questions to seek answers to when conducting your research.

Remember, with investing there are no sure bets. So keep that in mind.

What are small-cap ETFs?

small cap etf picture logo

If you are not inclined to sift through hundreds of individual small-caps, wishing instead to save time otherwise expanded on lengthy research, you could invest in an ETF tracking the small-cap sector.

An ETF that tracks a small-caps index gives you broad exposure to the sector.

For instance, the ASX-listed Vanguard MSCI Australian Small Companies Index ETF [ASX:VSO] tracks the return of the MSCI Australian Shares Small Cap Index, providing diversified exposure to small companies listed on the ASX.

Are small-cap ETFs worthwhile?

Small-cap ETFs let you buy a basket of small-cap shares in a single trade. This helps you diversify an investment within the asset class. With small-cap ETFs, you are not betting on any one individual stock but on the sector as a whole, mitigating risk.

ETFs are also low cost, cheaper than most actively managed funds.

And you can buy and sell small-cap ETFs directly on the ASX, making them easy to trade.

Of course, small-cap ETFs are not risk-free.

They track the performance of a sector known for its volatility and large swings. ETFs in small-caps usually suit long-term buy-and-hold investors whose investment horizon can withstand short-term drawdowns.

When should I invest in small-cap stocks?

Researchers have gathered plenty of persuasive evidence suggesting that market timing often leads to lower returns.

As the saying goes, we should focus less on timing the market and more on time in the market.

Figuring out the best time to invest in any sector is fraught with risk, as market trends can appear suddenly and almost randomly, rendering the risk of mistiming significant.

So when should you invest in small-cap stocks?

When your research, risk appetite and portfolio considerations lead you to believe the small-cap sector is a reasonable investment strategy.

The when may matter less than the why.

This is where you must search within and come up with an investment plan. Are you seeking dividend income? Are you seeking capital growth? Is your investment horizon five years? 15? One year? What risk can you assume? What risk does your financial position allow?

Pondering these questions will go a long way in informing the question of when to enter the small-caps sector.

For instance, a person verging on retiring is less likely to invest in small-caps than one just starting their career and seeking long-term gains.

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What is a penny stock?

Penny stocks are small-cap stocks selling for a very low price — often for the proverbial penny.

The terminology of a penny stock is more common in the US and the UK. For instance, the US Securities and Exchange Commission defines a penny stock as a company with low or micro market capitalisations, where market capitalisations can be less than $50 million.

Now, while all investments involve risk, penny stocks are among the riskiest.

Many penny stocks are new and have no established track record. Some even lack any assets, operations, or revenues. Others have products and services still in development, yet to be tested in the market.

Another risk with penny stocks is lower liquidity. Some of these stocks have low trading volume, making the sale of their shares harder. 

It’s best to do your due diligence and fully research fundamentals, business model, and prospects before considering investing in penny stocks.

How are penny stocks different from other stocks?

Apart from the basic difference of market size, penny stocks also differ from other stocks on other criteria.

Risk is a major difference. Penny stocks — and small-caps in general — incur greater risk than established companies with years of earnings, revenue, and coverage.

This also leads to another difference.

Penny stocks are often barely covered by the media or analysts. There is a lack of public information.

For instance, professional stock analysts regularly research and write about larger public companies like Commonwealth Bank of Australia [ASX:CBA] and CSL Ltd [ASX:CSL]. But analyst estimates and public information on penny stock companies can be difficult to find.  This raises another risk, as the lack of coverage makes penny stocks more vulnerable to investment fraud schemes.

What happens to small-caps when the economy goes bad?

This is one of the major risks associated with small-cap investing: small-caps can face more volatility than larger stocks, especially during economic downturns.

Small-caps tend to underperform large-caps in times of economic woe as they are perceived as riskier assets and more vulnerable to market shocks.

During the March 2020 crash precipitated by COVID-19, for example, the ASX Small Ordinaries Index fell more than the ASX 200. But as the market began to recover, the Small Ordinaries outperformed the ASX 200, neatly showcasing the risk-reward inherent in the small-cap sector.

That said, the small-cap universe is vast. Small-caps don’t move in unison. At the end of the day, small-cap stocks are individual businesses and should be appraised on that basis first and foremost.

It is also important to note that the stock market is not the economy. Moves in the wider economy do not have to perfectly correlate with moves in the markets, including the small-caps sector. While the stock market and the economy are not entirely disconnected, the two diverge much of the time.

Small-cap stock investing: a matter of risk and reward

Investing in small-caps is not for the faint of heart as they are riskier investments with more volatility. But if you understand the risks and have risk-mitigation strategies in place, small-caps may be an investment class for you to consider.

Investing is about balancing risk and reward. While small-caps can offer higher potential returns, they incur greater risks.

It is up to you how much risk you want — and can — take on.

Happy investing.

Kiryll Prakapenka is a research analyst focusing on investigating the biggest trends in investments. Kiryll brings sound analytical skills to his work, courtesy of his Philosophy degree from the University of Melbourne. A student of legendary investors and their strategies, Kiryll likes to synthesise macroeconomic narratives with a keen understanding of the fundamentals behind companies..

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