Small Cap Stocks

Of the approximately 2,000 companies listed on the ASX, just over 1,400 — or 70% — are below $200 million in market capitalisation. Approximately 60% of these 1,400 stocks have a market capitalisation below $50 million (at time of writing).

But while small-caps comprise the majority of the ASX, it is the bigger names that get most of the market’s attention. Names like BHP Billiton, Telstra, Commonwealth Bank, Woolworths, Wesfarmers — the list is long.

These big companies are popular with most investors. And, in a good year, they can see strong gains, sometimes between 20% and 30%.

But what the average investor might not realise is that some of the most exciting, interesting, and world-leading stocks with the potential for large returns are frequently found more often in the speculative small-cap sector.

ASX small-cap stocks

First, what are small-cap stocks?

They are all those companies that sit outside of the largest 100 on the ASX by market capitalisation.

The S&P/ASX Small Ordinaries Index represents the smaller constituents of the S&P/ASX300 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.

The small-cap space has more stocks to choose from but significantly less analyst coverage and lower institutional ownership.

This may sound unpromising for some, but it is precisely this that can make small-caps exciting opportunities.

Why?

One of the reasons is market inefficiencies caused by low analyst and media coverage create mispricing opportunities.

Small-cap stocks are largely misunderstood and underappreciated, and some can present great total return opportunity for discerning long-term speculators.

As there is less media and broker coverage, and competing investor attention in the sector, there can be a greater reward for investors’ own research, skill, and effort.

Are the most exciting ASX stocks small-cap stocks?

If one looks at ASX stocks worth less than $500 million, they can find some of the most exciting stocks in the world.

These small-cap stocks hold lots of potential because they can have plenty of runway left. Some small-caps can see price rises in excess of 100%, 200%, 500%, and sometimes even more than 1,000%. But it’s a high-risk, high-reward sector. You can just as easily lose some or all of your investment.

What are examples of small-cap stocks?

Take BrainChip Holdings Ltd [ASX:BRN] — an edge AI applications developer, for instance. BrainChip was trading for 8 cents in June 2020 before jumping to 76 cents in September 2020, a gain of 800%.

It is also an example of what is called a multibagger stock — a stock that gains over 100%.

Or take, for instance, another multibagger — Novonix Ltd [ASX:NVX], a battery materials and technology company. It gained over 750% from May 2020 to October 2020.

And while not all small-caps rise like these mentioned, such gains are possible because small-cap stocks can make one big deal, or sign one crucial agreement, or surprise the market with one big announcement — and see the value of their company skyrocket virtually overnight.

That could turn a stock worth a few cents into one worth a few dollars in a short space of time. And it could supercharge an investment portfolio in a way that almost no large company can.

Are small-cap stocks risky?

Yes, small-cap stocks are very high risk.

Because of their size, small-caps are extremely volatile and can have big price swings daily. And while this volatility is what can deliver such lucrative returns in small-caps, it can also just as easily deliver huge losses.

Thus, it is frequently suggested to never put all of one’s money in this part of the stock market. And certainly, never invest more than you are prepared to lose.

It’s important you are aware of this risk/reward payoff before exploring this sector.

Investing in small-cap stocks

Small-cap investing is as much about what to own as what to avoid.

After all, more than 60% of all small-caps delivered a negative return over the 10 years to 2020, leaving less than 40% from which to make money.

Investing in small-caps, therefore, can take a certain level of investing acumen, experience, and steel. As well as a high tolerance for risk.

This is especially true when considering the sheer number of investment opportunities in this market sector.

Investing in this market also requires equanimity in the face of drastic price swings. And equanimity usually follows conviction.

What strengthens conviction? Intelligent research.

When purchasing a car, we consider its price, fuel consumption, safety…we conduct test drives. We do all this as part of our research before parting with our hard-earned cash.

It’s the same principle with buying shares, especially in the small-cap space.

It all comes down to finding quality and avoiding hollow hype.

What are some ways to assess a small-cap stock’s quality? One can consider the stock’s:

  • Business model
  • Industry
  • Stage of life cycle
  • Management
  • Growth strategies
  • Industry cyclicality
  • Geographic exposure

The more one understands a company and industry, the more comfortable one is with their investment decision. As Warren Buffett said, ‘Never invest in a business you cannot understand.’

Apart from conducting due diligence on a stock, one can also consider implementing stop-losses (ie: an exit price if things don’t work out) and limiting one’s position size (for example, keeping a trade to 5% of one’s portfolio).

That said, rigorous research — with the associated sifting, filtering, identifying, assessing, and modelling stocks — can be a full-time job.

That’s why investors frequently make use of research reports by professional analysts to save time.

On that note, there is an underreported resource out there for small-cap investors — the ASX Equity Research Scheme.

The free, ASX-backed scheme provides subscribers ‘high quality, independent research for undercovered ASX-listed small cap companies.’

Under the scheme, the ASX subsidises equity research on eligible companies by partnering with several well-established research brokers working in the small-cap space.

Since inception, the scheme has covered companies like Altium Ltd [ASX:ALT], Afterpay Ltd [ASX:APT], Vocus Group Ltd [ASX:VOC], and Nearmap Ltd [ASX:NEA].

Research from the ASX Equity Research Scheme is published in a weekly email bulletin to subscribers on Friday afternoons, with an average of six research reports per week.

Additionally, if you were so inclined, you could also check out our paid services catering exclusively to small-caps: Australian Small-Cap Investigator and Exponential Stock Investor.

Australian Small-Cap Investigator has had a fair bit of success since the newsletter was first published back in March 2007, concentrating on companies whose shares trade for cents on the dollar — and are often shunned or ignored by those in the financial services industry. It has a simple mission: to make you lucrative gains from small stocks.

Exponential Stock Investor takes a more thematic approach to small-caps by hunting down potentially exponential opportunities by identifying small-cap disruptors and innovators riding the fastest growing trends in the market.

Both services have made numerous 100%-plus gains for some subscribers since their respective inceptions. While such success can never be guaranteed, you can certainly see the potential on offer when we get it right.

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Trader’s Corner — Why Do You Trade?

There is satisfaction in seeing the long-term trading stats sit around expectations. The joy is in seeing a lack of volatility in my P+L, rather than being elated when it’s rising and despairing as it falls.
Money Morning Australia