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 1 January 2000 to 31 December 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 in the vanguard of industry disruption. Many have also embraced the internet, giving them a material advantage over better-resourced larger competitors. Take Just Eat. It has revolutionised the way we order food – leaving larger businesses playing catch-up. 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.
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.
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 a 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 we 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.
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 diverse their portfolios and potentially achieve robust long-term returns, we believe small-caps represent a compelling investment opportunity.
*Source: Thomson Reuters Datastream, USD, 31 December 2018
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