Small-cap stocks have always received mixed reviews. You either hate them or you absolutely love them.
But before you take a stand on small caps, take a peek into what they are, what they offer and most importantly, what is the story behind them.
Not all small-cap companies are the same. There are some really good ones out there with a fantastic story to tell, accompanied with possible great growth potential ahead.
Firstly, what is market capitalisation?
Market capitalisation is used to show the size of a company.
The company size is a basic determinant of various characteristics in which investors are interested, including risk.
It also helps that it is simple to calculate - a company with 40 million shares selling at $100 a share would have a market cap of $4 billion.
Market capitalisation refers to how much a company is worth, as determined by its share price on the stock market – the total market value of all of the company’s outstanding shares.
Market cap, as it is often called, is used to size up a company and to understand the aggregate market value.
To calculate a company’s market capitalisation or market cap, one multiplies the number of outstanding shares by the current market value of one share.
Outstanding shares refer to a company’s shares held by all shareholders, including shares held by institutional investors and company officials.
Changes to market cap
Needless to say, the market cap of a company can rise and fall sharply, depending on the share price of the company on a particular day.
Changes to the number of outstanding shares, however, are not frequent, unless the company has just undertaken a capital raising exercise that covers the issue of new shares, including share options – anything that increases the number of shares in the market.
Sometimes the purchase of an asset could involve the issue of new shares as well.
Therefore, although changes in market cap are largely attributed to changes in the price of the shares of a company, do keep an eye out on corporate developments that could change the number of outstanding shares.
It is not uncommon to see companies moving from a small-cap to a mid-cap or large-cap, depending on the change in their market cap valuations.
Different types of companies
Large caps – These are the biggest companies listed on the ASX in terms of market cap.
The S&P/ASX 50 is comprised of the 50 largest companies, representing over half of the Australian share market by market cap. The market cap of these securities generally ranges between tens of billions to over $100 billion.
Mid-caps - These are the next 50 biggest companies on the ASX in terms of market cap.
Small caps are companies that fall outside of the largest 100 on the ASX by market cap.
The S&P/ASX Small Ordinaries index (XSO) represents those smaller members of the S&P/ASX300 index.
It is used as a benchmark for small cap Australian shares.
Companies in this index generally have a market cap of a few hundred million dollars to $2 billion.
Historical analysis shows mega- and large-caps often see slower growth with lower risk, while small-caps have higher growth potential but this comes with a higher risk.
That is why, sometimes, small caps are often described as growth stocks.
Another factor often overlooked is, most investors avoid small-cap stocks because information on them is not readily available compared to large and mid-cap companies and analysts often do not pay much attention to them.
This often leads to a higher chance of improper pricing of certain small-cap stocks. For instance, a fantastic announcement by a small-cap company may not see its share price rise to reflect this, due to the inefficiencies in the market pricing.
But if you are a shareholder or buy into this stock at the right time, you are ready to make a ‘killing’ when the market does wake up and realise that the company is a great buy!
Another factor is most investment houses like financial institutions, mutual and hedge funds are stopped by rules and regulations from investing too much in small cap stocks.
This is a good thing as the share prices of small cap companies, therefore, do not get artificially pressured or raised when a large financial institution decides to sell or buy the stock.
Let’s face it. A small cap company can never beat a blue-chip company on dividends.
But the truth is, you need to ask yourself what you want – an income now or growth in the future.
And there is the issue of how soon you can get your returns. Dividends do come in regularly, although they are not necessarily assured.
But growth can take time.
Volatility and liquidity
And yes, small-cap stocks are often subject to a lot of volatility due to various reasons, including the fact that they only have a small number of shares trading in the open market.
Another concern is sometimes the lack of liquidity, which often puts off investors.
Outperform the main index
As small-cap companies are companies with low share prices, they can grow really quickly in ways that are just not possible for larger companies.
But a key factor to remember about small caps is that small-cap value index funds tend to outperform the main index in the long run.
And most importantly, it is their growth potential that you are looking at.
Risk vs rewards
It is often portrayed that investing in small-cap stocks is too risky for various reasons.
That may be true for some and especially if you are comparing them to blue-chip companies.
But at the end of the day, it is up to the investors to sieve through the list and pick out the ones with good potential - not just in share price but also growth in activities.
Really up to you!
Of course, it is. Any investments carry their own levels of risk.
The important thing is to know what your risk levels are, that is how much money you can afford to lose against how much returns you are seeking.
Like life, it is all a matter of balance.
At the end of the day, whether you wish to dip your toes into investing in small caps, should depend on your risk profile and how good you are at sniffing out really good small-cap companies