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Small cap investing – your questions answered

What are small caps?

Small-caps are small companies – not micro businesses - but not very large organisations. Definitions vary, but a rough rule of thumb is that they have market capitalisations (market worth) of between £100m and £2bn– which on the face of it doesn’t seem very small. But it is small when you compare it to an Apple ($2.3trn) or a Microsoft ($2.2trn market cap).  

Small-caps might be listed on a stock exchange, for example, on the AIM market in the UK, or the NASDAQ in the US. Or they might be privately owned, by a family or a private equity firm.

What is small-cap investing?

Small-cap investing is literally buying shares in small-cap businesses, 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 increases in value, as investments in smaller companies are high-risk. 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.

What are the benefits of small-cap investing?

Small-cap investing is riskier than large-cap investing, as small companies are seen as more likely to fail. That said, there are a lot of benefits to investing in smaller companies. These include:

  • Growth: if the companies grow in size, this growth is more likely to be reflected in the value of your investment. And relatively, growth can happen much more rapidly than in larger organisations. It can take a long time for a large organisation to double in size – but growing by 25%, 50% or even 100% is much more common in the smaller cap universe.
  • IPOs (initial public offerings): if a small company is privately owned but then the decision is made to list it on a stock exchange (such as AIM, which specialises in smaller companies), then this is an opportunity for investors to increase the value of their holding – obviously, this isn’t always the case. Some companies devalue after their IPO, but a significant percentage of IPOs are deemed to be successful.
  • M&A: due to their more accessible size, there tends to be more takeovers within the smaller-cap community, so smaller companies are more likely to buy their competitors or be sold to competitors compared to larger companies. These scenarios could potentially create an opportunity for investors to increase the value of their holding.
  • Strong positions in niche markets: niche businesses are companies that satisfy a really specific market need. This can either be a smaller, mature market that is more isolated from disruption – the markets are usually small enough that large-caps wouldn’t justify the cost of entry – or they can be 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 – this is a big growth sector within small caps.
  • Ability to roll out business plans: these are 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.
  • UK – more tech in small-caps: there is a real dearth of tech stocks in UK large cap – and tech has been the real growth story of recent years (look at what we call the FAANG stocks – the Facebooks, Amazons, Netflixes etc.), but there is a significant quantity of tech stocks in the small-cap sector too.

Are small-cap stocks riskier?

Investing in small cap stocks can be riskier for a number of reasons.

  • The general perception is that larger organisations are by their nature safer – they are much less likely to go bust than small firms.
  • 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.
  • Smaller companies are also much less liquid than larger companies meaning that they have access to less cash – smaller companies tend to invest their capital in future growth – so for investors, they might not be able to liquidate their investment (i.e. get their cash out) as easily as they might in larger companies.
  • 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 ground work 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.

It is always advisable to discuss small-cap investing with your investment manager or wealth manager.

Is it better to invest in small or large-cap?

Whether it is better to invest in small-caps or large-caps depends on your personal situation and your risk appetite.

It is not always the case, but small-caps are often related to growth investing – for investors who want to make money from the trajectory of the company’s growth (and if a company’s value increases, so do the value of your shares).

And it isn’t always the case, but large caps often tend to be related to income investing (this is generally in the UK – in the US, many large caps are growth tech stocks) – investors will make money from the companies they invest in paying out shareholder dividends. Investing in larger companies is also often called ‘quality investing’ – there is an assumption that larger companies will be higher quality (better run, subject to more stringent governance etc) – although this is a generalisation and isn’t always the case.

Depending on your risk profile and your position, there might be room for small caps in your portfolio. It is dependent on the individual investor’s situation. It is all about achieving the balance that is right for that investor.

It is always advisable to discuss small-cap investing with your investment manager or wealth manager to see if it is suitable for you.

How much should I invest in small-caps?

How much you invest in small-caps is relative to your situation and related to what your risk appetite is 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 pay outs 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 – investors who make money from the growth and success of the companies they invest in – buying shares at a certain value and trying to sell them for more. With a higher level of risk, you could potentially allocate more of your investments to smaller-caps. Ultimately it will depend on your personal situation, so speak to one of our wealth managers before deciding what is right for you.

When might small-cap investing be a good idea?

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.

For more information regarding investing in small caps:

To find out how we distinguish between different risk profiles, you can download ‘Our investment risk framework’ here. A portfolio consisting of only small cap investments would be classified as a Risk 8 or 9, our highest risk profiles.

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Investments in smaller companies, including AIM stocks, carry a higher degree of risk than investing in more liquid shares of larger companies, so they may be difficult to sell at the time you choose. Investments in smaller companies are more volatile and, while they can offer great potential, growth is not guaranteed.

Investment involves risk. The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested. Past performance is not a reliable indicator of future performance.

The information provided is not to be treated as specific advice. It has no regard for the specific investment objectives, financial situation or needs of any specific person or entity.

Investment involves risk and you may not get back what you invest. It’s not suitable for everyone.

Investment involves risk and is not suitable for everyone.