The small- and micro-cap sectors are risky and volatile. But with careful research and patience, investors could make huge gains. Matthew Partridge explains how to find the market’s top tiddlers.
For many people, the term “small-caps” conjures up images of dodgy penny shares hawked over the phone by people in boiler rooms. In truth, depending on the precise definition you use, the small-cap universe can include stocks with market capitalisations of up to £1bn, while even so-called “micro-caps” can be as large as £250m. The sector includes some of the most dynamic and fast-growing companies in the UK and around the world. If you’re prepared to do some basic research and be patient, they can prove very lucrative.
Hidden gems
There are two main reasons that it makes sense to eye up smaller companies. Firstly, unlike their larger counterparts, they are generally ignored by most financial professionals, with many fund managers barred outright from investing in them. As a result there are also fewer investment analysts researching them, says Eustace Santa Barbara, who co-manages the Marlborough Special Situations fund with Giles Hargreave. That creates “more opportunities for investment teams… to uncover hidden gems with growth potential that hasn’t yet been priced in by the wider market”. Smaller companies also have much more scope for growth. Sales and profits can rocket off a low base, while it is extremely hard for a blue chip’s figures to rise by a similar percentage.
The universal size effect
Given these factors, it should come as no surprise that small shares have historically outperformed their larger counterparts. According to research by Elroy Dimson, Peter Marsh and Mike Staunton of the London Business School, £1 invested in large-cap UK stocks in 1955 would have been worth £1,225 by the start of last year. The same amount invested in small- caps would have soared to £8,200. And had you opted for micro-caps (as defined by the smallest 1% of listed companies) you would now be sitting on a portfolio worth £33,011.
The UK isn’t the only market to experience this size effect. Micro-caps have outperformed both large caps and even smaller companies in the United States, with annual returns of 12.7% over the last 92 years, compared with 9.9% for the largest companies. While this is a more modest gap than in the UK, this still means that $1 invested at the start of 1926 would have grown to $60,276 if you had put it into the smallest companies, compared with only $5,767 for blue chips. Overall, Dimson, Marsh and Staunton found that the smallest firms had the highest returns in virtually every major stockmarket around the world (the one exception being Norway).
Of course, long-term averages only reveal part of the picture. The flipside of high reward is high risk; many small companies go down in flames. Even if they don’t, they will be more volatile than their large-cap counterparts since they are small enough for even minor purchases or sales to shift the price significantly, while they are also less liquid. In addition “transaction costs are higher and small-cap portfolios are costly to manage”, as the London Business School’s Paul Marsh points out. This can be a major drag on returns if you buy and sell them frequently. Still, these negatives have the advantage of keeping prices low, thus keeping a lid on valuations and implying robust long-term returns. There is “good reason” to expect them to “continue generating larger returns over the long run”. Indeed, the FTSE SmallCap index has beaten the wider market over the last three, five and ten years.
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