Should you invest in small caps?
With small capitalisation stocks gaining momentum, there are important considerations to determine whether they are right for your portfolio.
A small capitalisation stock (“small cap”) refers to a company with a market capitalisation (“market cap”) generally between $300 million and $2.5 billion. It is important to note that the range for classification can differ. Morningstar defines the term as companies in the bottom 10% of the capitalisation of an equity market.
In Australia, a good way to categorise these stocks are whether they are in the S&P/ASX Small Ordinaries Index. The index is designed to measure companies included in the S&P/ASX 300, but not in the S&P/ASX 100. Notably, the largest constituent in this index, Life360, has a market capitalisation of ~$3.9 billion.
What are the investing risks?
Liquidity constraints
Smaller companies tend to pose risks to liquidity as they logically have lower trade volumes. Purchasing or selling the stock becomes difficult if it is not met with adequate supply and demand. Investors that have shorter time horizons or rigid liquidity requirements should heed caution as the shares may be difficult to sell if the market does not show demand.
Price volatility
Echoing the above sentiment, low trading volumes also lead to price volatility. A reasonably sized trade that wouldn’t typically affect a large cap stock, may spike or decimate the share price of a small cap in the short term. If an investor has a short term withdrawal date for funds, they may find themselves privy to the whims of small cap price volatility and forced to sell at a loss if the market doesn’t encourage organic share price growth. Further, volatility or market moving events can often spook novice investors into the panic selling spiral, selling during downturns and locking in losses.
Uncertain income
For those that seek to draw income from their investments, small caps are unlikely to achieve their goals. Majority of small caps are in the growth phase of the business cycle meaning that capital allocation is more likely to focus on reinvestment opportunities, rather than the distribution of capital as dividends to shareholders.
Lack of information
Smaller public companies disclose the same information that is legally required as a larger traded company; however, their presence typically commands less scrutiny from professional investors and the media. For this reason, Australia’s mid/small blend favour active fund managers who are generally at an advantage to exploit informational inefficiency with wider access to resources.
Figure 1: Good manager selection is paramount. Source: Morningstar Direct. Data as of June 30, 2024. Calculations for 10-year period ending June 30, 2024. Returns have been annualized.
Furthermore, analyst coverage tends to shrink as market cap becomes smaller which may lead to an increase in the deviation of fair value estimates and snowball into mispricing.
The above provides a brief overview of some of the investing considerations surrounding small caps, you can explore our Investing Compass podcast episode for a more comprehensive understanding.
Australian small cap market
Intuitively, smaller companies have more room to grow, with consistent large cap rallies leaving few attractive options given the ASX 20 trades at a cap-weighted premium of almost 20% to fair value. Whereas companies outside the ASX 100 trade much closer to fair value. Almost 40% of small caps in Morningstar coverage are four or five star rated compared to 30% in the ASX100.
The rationale for investing in small caps is highly contentious as Australian players have weathered a tough few years of returns in comparison to their larger counterparts.
ASX small caps have historically underperformed their larger peers and are also typically of lower quality. This should be enough to sound alarm bells for any investor, however the asset continues to gain renewed interest amidst global monetary loosening.
Figure 2: The Small Ords have underperformed its large cap counterpart. Source: VanEck, 2024.
The impending rate cut environment proves favourable for small caps who collectively rely more heavily on external financing than their larger peers. Historically rate cuts have led to overall market rallies however small caps have outperformed in these instances.
Figure 3: Small & large cap equity returns during low and high rate environments. Source: Polaris Capital. 2024. Note: Low-rate environment defined as period from November 30, 2008 to March 31, 2022. High-rate environment defined as period from March 31, 2022 – August 31, 2024.
Unlike Australian small companies, global smaller caps have historically outperformed relative to large companies over the long term. It serves as an important lesson that market trends aren’t always globally transferrable. This article doesn’t make the case to invest solely in global small caps but instead encourages investors to understand the nuance between the Australian and global market composition.
Figure 4: Cumulative historical performance of global large caps versus small-caps. Source: VanEck, 2023. Note: Global Large Caps is MSCI World ex Australia Index, Global Small Caps is MSCI World ex Australia Small Cap Index. 31 December 1999 to 30 April 2023, returns in AUD terms.
The Australian small cap environment is constrained by structural nuances that aren’t present globally.
Size and business cycle
The first consideration is the size of the Aussie market. Research found that globally categorised ‘small caps’ are on average, two times larger than their Australian peers. To further exemplify this difference, the largest global small cap on the MSCI World Small Cap index would rank approximately 20th largest on the ASX.
Consequently, the lower relative market cap of Aussie small caps implies that the companies on the ASX Small Ordinaries index are more likely in their infancy stage, with mixed sales and earnings growth numbers. This is reinforced by studies show that global earnings per share growth of small cap benchmarks outperforming their Australian counterparts by a significant margin.
Figure 5: EPS growth comparison. Source: VanEck, 2023.
Composition
As observed on the pie chart below, materials are the largest segment of the ASX Small Ordinaries. Research finds that local small caps have an abnormally high number of unprofitable businesses, primarily in the mining space. Many of these companies are junior players in the exploration and development phase. Given the limited funding opportunities at this stage of infancy, these miners primarily raise capital through public offerings as opposed to traditional debt financing.
Figure 6: Sector allocation of S&P/ASX Small Ordinaries. Source: S&P Global. 2024. Visualisation by author.
This contrasts with international small caps. If we take Vanguard MSCI International Small Companies Index ETF for example, the sector composition looks vastly different with an emphasis on industrials and financials.
Figure 7: Sector allocation of Vanguard MSCI International Small Companies Index ETF. Data Source: S&P Global. 2024. Visualisation by author.
Lessons taken
If you’re wondering if small caps investing might be for you, there are several things to consider before taking the plunge. The most important factor is your investing time horizon. Investing at an early stage means you must stay invested long enough for the company to realise its organic growth prospects and for the market to recognise future earnings potential. It is important to note that growth is not always a given, with many small caps running the risk of business discontinuity.
“Don’t dumpster dive” … This lesson from our recent take on Aussie Small Caps rings true as I recall a lithium small cap (arguably micro-cap) I speculatively threw $1,000 in, bolstered by the promise of continued lithium demand. Although this purchase was a small blip in a larger pattern of speculative picks I made in my early 20s, it was still indicative of the pitfalls investors face with small caps.
As discussed above, one reason Aussie small caps have consistently underperformed larger peers is sector composition. Compared to global indices, Australian small caps have an abnormally high share of unprofitable businesses with larger weighting in basic minerals – many of which are junior miners still in the exploration phase.
In 2022 I invested into Lake Resources (ASX: LKE), who is involved in the exploration and development of ‘cleaner’ lithium. The company rallied multiple times during the lithium bull run during Covid-19 and received investment from Lilac Solutions, a partner to Bill Gates’ Breakthrough Energy Ventures fund.
My rationale was that the company’s small capitalisation would provide a sizeable growth runway to exploit continued lithium momentum. However, these hopes came to a halt as lithium prices went crashing down. The company’s primary exposure to lithium and lack of operational assets saw investors lose confidence in their ability to turn a profit.
Price induced swings are a variable faced by all commodity players, however large companies are typically cushioned by stronger balance sheets, asset diversification and share liquidity to weather the storm. To this day Lake Resources isn’t profitable, and its flagship project is estimated as 6 years behind schedule with non-core asset sales providing only minor liquidity relief. Notably, unlike many of its small cap peers, Lake Resources currently holds no debt meaning that interest rate fluctuations and the cost of borrowing are not a consideration here.
The mistake I made was panic selling at a loss – every rookie investor’s Achillies heel. In retrospect, given the renewed lithium outlook, some patience may have boded me well enough to weather the lithium bear cycle.
Every small cap is different and investments should be based on tangible returns rather than speculative calls.
Stay Tuned for our top ASX picks
Follow along for my next article that will outline two ASX small caps that currently offer great value.
