Great things come in small packages

We all have to start somewhere. The business world is no different. Apple began in a garage; Virgin in a church crypt. These two firms are now household names. For investors, ‘smaller companies’ can offer the opportunity to gain access to tomorrow’s giants – today. That’s why we think you should consider an allocation to small-cap equities as part of your wider investment portfolio. The potential rewards for doing so are clear.

Punching above their weight

Small-caps have outperformed larger peers across most timeframes and most geographies.

As an asset class, they have outperformed larger peers across most timeframes and most geographies. From January 1, 2000 to December 31, 2018, small-caps delivered a positive cumulative return of 362%. This compares to a 139% return for the MSCI All Country World Index (which excludes small-caps).*

This outperformance is because smaller companies tend to grow much faster than their large-cap equivalents. Due to their size, they can quickly adapt to new market trends. Small-caps are often the vanguard of industry disruption. Many have also embraced the internet, giving them a material advantage over better-resourced larger competitors. Smaller companies also have growing economies of scale, creating a tailwind for earnings and profits.

Doing your homework

Despite this, analyst coverage of small caps can be poor. This is understandable. Around 70% of the world’s listed companies are small caps. It therefore requires considerable resources to cover the sector. Information on many companies can be sparse. Due diligence is often time consuming and costly. However, this lack of coverage means there is greater potential for mispricing to occur. A company’s share price can often soar once the market finally spots its worth. Small caps represent a wealth of promising opportunities for active investors willing to do their homework.

Diversification benefits

Smaller companies also offer diversification benefits as part of a wider portfolio. They can provide different sources of returns to larger caps. Small caps tend to be more domestically focused than their bigger, international rivals. Investors can therefore gain direct access to expanding local economies or sectors. Small caps are also potentially less vulnerable (although not immune) to global trends and currency fluctuations.

Risky business?

Of course, there’s no ‘free lunch’ in investing. Higher returns come with higher risk – and small caps are no different. Over time, the asset class has delivered more volatile returns than larger companies in most regions. Small-cap shares are often the first to fall when the economy turns. There is also liquidity risk. Fewer investors hold an individual smaller company’s shares, making them harder to sell in a market downturn. This can compound share-price falls.

Successful investing requires a deep understanding of these risks and the potential rewards they offer. This is why many investors take an active approach to small-cap equity investing. Indeed, price volatility often creates opportunities. Share-price drops allow alert, long-term investors to buy good companies at attractive valuations.

Final thoughts…

In our view, the case for investing in smaller companies is strong. The asset class has historically outperformed large-caps. The investment universe contains a wealth of exciting, fast-growing and innovative businesses. True, investors will have to tolerate a level of volatility. However, for those looking to diversify their portfolios and potentially achieve robust long-term returns, we believe small-caps represent a compelling investment opportunity.

*Source: Thomson Reuters Datastream, USD, December 31, 2018

Important information

Diversification does not ensure a profit or protect against a loss in a declining market.

Companies mentioned for illustrative purposes only and should not be taken as a recommendation to buy or sell any security.

Equity stocks of small and mid-cap companies carry greater risk, and more volatility than equity stocks of larger, more established companies.

Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.

The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis, should not be taken as an indication or guarantee of any future performance analysis forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI” Parties) expressly disclaims all warranties (including without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages (www.msci.com).

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RISK WARNING

The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.

AAM Group