Small-cap investing

Small-cap investing is literally buying shares in smaller companies, with the objective of seeing them grow and generating a return on your investment. It is often called ‘growth investing’, as the value of the company will – hopefully – grow for the duration that you invest in it. So, if, for example, you buy shares for £5 a share and the company doubles its market capitalisation, you might be able to sell your shares for £10 a share.

Whether or not this happens is subject to many different variables – and investors need to be mindful that the company they invest in could lose value as easily as it could increase in value. Investments in smaller companies are high-risk and they tend to be more volatile and illiquid. Selling may be difficult, and they can fall further than the wider market. They are more exposed to fluctuations in the domestic economy and growth is not guaranteed. Therefore, they are not suitable for all investors.

Smaller companies  are not micro businesses like your local coffee shop or boutique. Smaller companies can be well-established market leaders and household names, expanding businesses or those carving out a niche in certain markets. Smaller companies’ market capitalisations are relatively small i.e. the value of the company that is traded on the stock market calculated by multiplying the total number of issued shares by the present share price. A rough rule of thumb is market capitalisations (market worth) of between £100m and £2bn– which doesn’t sound small until you compare it to an Apple ($2.44trn as at 28 September 2022) or a Microsoft ($1.76trn market cap as at 28 September 2022).

So, by smaller companies, we mean those that are:

• Listed on AIM - these companies can have a market capitalisation above £2bn.

OR

• Have a market capitalisation of less than £2bn and not within the FTSE 100 – this includes companies within the FTSE 250, FTSE Small cap and FTSE Fledgling Indices.

Small-cap investments can deliver superior returns and growth. Historically small-cap stocks have outperformed large-cap stocks, but they are a more volatile investment and come with a higher risk. That’s why it’s important to have a small-cap investment specialist by your side.

Data as at end July 2020. Source: FTSE and Bloomberg.

The benefits of small-cap investing include:

Growth:

Relative to larger organisations, small-caps can grow much more rapidly, which is more likely to be reflected in the value of your investment. It can take a long time for a large organisation to double in size – but, if they grow, growing by 25%, 50% or even 100% is much more common among smaller companies.

Initial Public Offerings (IPOs):

If a small company is privately owned but is then listed on a stock exchange (such as AIM) this is an opportunity for investors to increase the value of their holding, although this isn’t always the case as some companies devalue after their IPO.

Mergers & Acquisitions:

Smaller companies are a more accessible size, so there tend to be more takeovers within the small-cap community. Compared to larger companies, smaller companies are more likely to buy their competitors or be sold to competitors, which could potentially create an opportunity for investors to increase the value of their holding.

Strong positions in niche markets:

Niche smaller companies satisfy a very specific market need. This can either be a smaller, mature market that is more isolated from disruption – niche markets are usually small enough that large-caps wouldn’t justify the cost of entry – or they are rapidly growing small markets that haven’t attracted the attention of a bigger operator in a related field. An example could be the gaming sector in the UK – a big growth sector within small-cap investing.

Ability to roll out business plans:

These are smaller companies that have a proven and successful offering and are in the process of rolling out their product to new markets either in phases or store by store.

More tech in UK small-caps:

There is a significant quantity of tech stocks in the small-cap sector and a real dearth of tech stocks in UK large cap despite tech being the real growth story of recent years (look at the Facebooks, Amazons, Netflixes etc.).

Whether it is better to invest in small-caps or large-caps will depend on your personal situation and your risk appetite. It is all about achieving the balance that is right for you.

Small-caps are often related to growth investing, although this is not always the case. Investors want to make money from the trajectory of the company’s growth; if a company’s value increases, so does the value of their shares.

Large-caps on the other hand are often related to income investing or ‘quality investing’, although this is not always the case. Investors will make money from the companies they invest in paying out shareholder dividends.

Small-cap investing is usually riskier because:

1. The general perception is that larger organisations are by their nature safer – they are much less likely to go bust than smaller companies.
2. Smaller companies tend to have a more volatile trajectory – their growth can be far more rapid than their larger counterparts, but similarly, their decline can be just as rapid.
3. Smaller companies are also much less liquid than larger companies. They have access to less cash as they tend to invest their capital in future growth, so investors might not be able to liquidate their investment (i.e. get their cash out) as easily as they might in larger companies.
4. Smaller companies also tend to fly under the radar a bit more (they don’t attract as much analyst coverage as larger firms) so investors need to do a bit more groundwork to understand what they are investing in. It is also a reason why investing in a fund that focuses on the small-cap universe is usually a safer option than investing directly in small caps – the fund manager is more likely to be a small-cap expert than you.

How much you invest in small-caps depends on your situation and should be proportionate to your risk appetite, i.e. the level of risk you can afford to take.

If you are a pensioner or approaching retirement, you are more likely to have a lower level of risk and more likely to be an income investor (investors who make money from dividend payouts from the companies they invest in).

If you are younger and are likely to be investing in the markets for a long time to come, or if you have a large amount of investable capital then you probably have a higher level of risk tolerance and are more likely to be a growth investor (buying shares at a certain value and trying to sell them for more).

If you were happy with a higher level of risk, you could potentially allocate more of your investments to small-caps. Ultimately, however, it will depend on your personal situation, so speak to one of our wealth managers before deciding what is right for you.

When economies emerge from recession or a period of slow growth and start to grow again, this can be a good time to consider investing in smaller companies as it tends to be a time for fairly rapid growth. This means growth investors may see returns on their original investments more quickly than they might at other times of the economic lifecycle.

Market corrections provide good opportunities for investors. If markets experience a period of volatility and drop off in value, this often equates to a good buying opportunity for investors because when markets rise again, so do the value of their investments.

• Adam Caplan, Senior Investment Director / Team Leader
• Adam Newman, Investment Director
• Alex Van Moppes, Investment Director
• Andrew Findlater, Investment Director
• Dan Marks, Investment Director
• Ian Berry, UK Small Cap Equity Analyst
• Laurence Leigh, Investment Manager
• Leon Shuall, Investment Director
• Paul Parker, Senior Investment Director – Head of IHT Investments
• Richard Champion, Co-Chief Investment Officer
• Russell Wynn, Stockbroking Director
• Simon McGarry, Head of Direct Equity Research