Small-caps can be big winners
If you want to make big money from investing in the stock market over the longer term, it can pay to think small.
Too many private investors overlook smaller companies, either dismissing the sector as too obscure or too risky.
Smaller companies may lack the profile of larger company indexes such as the US S&P 500 or FTSE 100, but they have far greater growth potential and offer some of the most exciting investment returns of all.
They can certainly be more volatile, at least in the short term, but there are ways of spreading and reducing your risks.
No investor should put all their portfolio into this sector, but given the consistently strong performance over the long-term, they cannot afford to ignore it either.
Small stocks, big returns
The smaller companies mutual fund sector has enjoyed a blistering five years of turbo-charged growth.
The top three performing global investment fund sectors over the past five years all hail from this sector.
Japanese Smaller Companies is the best performing investment sector of all, with the average fund growing at an astonishing 130 per cent over the past five years, according to figures from TrustNet.com.
Satoshi Marui, the chief portfolio manager of SuMi Trust Japan Small Cap Fund, says global small caps strongly outperformed large caps in 2016, and Japan was no exemption. “Since prime minister Shinzo Abe came to power in 2012, investors who had previously been sceptical about Japan’s growth potential have been returning to the market with a focus on mid-caps and small caps, which have continuously outperformed,” he says.
Mr Marui anticipates another healthy year for the Japanese stock market, with smaller companies outperforming again. “We believe that large caps, which are mainly exporters, will be volatile as they are subject to swings in the currency markets, while small caps, which are mainly domestic-orientated, will be supported by steady economic growth.”
North American Smaller Companies also performed strongly, with average sectoral growth of 120 per cent, then European Smaller Companies, which defied the continent’s economic and political troubles to grow 117 per cent. The UK Smaller Companies sector was in sixth place, returning 104 per cent. This astonishing success rate comes as confirmation that small really is beautiful.
Compare those rates of return to, say, the much-hyped absolute return sector, which has given investors a return of just 17 per cent over the last five years. You could have earned more than seven times as much from investing in smaller companies.
Global emerging markets was once red hot, but it returned a relatively lowly 35 per cent over the past five years.
As always, past performance is no guarantee of future returns, but if you have little or no exposure to this sector, it may be time to think big about smaller companies.
Peter Garnry, the head of quantitative strategies at Saxo Bank, says the recent performance of Japanese, North American and UK smaller companies gives investors a good reason to look afresh at this sector. “Too many investors stick to large-name stock markets when smaller company funds can offer far more dramatic returns,” he says. “Many think they are too risky but if investing for the long term, you could be missing out on major growth prospects.”
History shows that so-called “small-cap” stocks, companies with a relatively small market capitalisation, deliver higher returns than large-cap stocks, albeit with greater volatility.
“During recessions, small-caps typically suffer larger declines because they have less access to credit markets to fund themselves,” says Mr Garnry, adding that their valuations tend to be higher, while earnings are lower, which can make for a bumpy ride when recession hits. “Bankruptcy probability is generally higher and liquidity is lower, with fewer people trading these stocks, so when a small company reports a bad quarter the price swings are larger.”
He warns that it is also more expensive to trade small-cap stocks as the bid-ask spread, which measures the difference between the price you pay when buying a stock and the price you get when selling, is considerably wider. “On the other hand, the rewards can be huge because it is much easier for a small stock with a market value of US$500 million to increase its value 10 times than for, say, Apple, with a market value of $797 billion.”
Mr Garnry says your decision to invest partly depends on your own attitude to risk. “If seeking high returns over the long term, adding small-cap stocks to your portfolio is a good idea.”
Older investors approaching retirement and seeking a reliable income stream should look elsewhere.
There is no single, universal definition of a small-cap stock, but they are typically viewed as companies with a market capitalisation of between $250m to $1bn. Companies valued below $250m are called micro caps.
If you want to make real money out of investing in smaller companies, you will want to research and buy individual stocks.
However, most ordinary people should resist the temptation, as a hot smaller company stock tip can quickly turn cold.
Take, as just one example among many, the UK small-cap Monitise, a digital technology group specialising in the ground-breaking area of mobile payments, whose stock flew to the heady height of £0.80 (Dh3.8) per share in February 2014.
The founder Alastair Lukies claimed that it could become a British technology powerhouse, but Google and Amazon killed the business case by developing their own mobile wallets.
Monitise is still in business but its shares trade at just above £0.02. Somebody who has invested, say, £10,000 at its peak would hold stock worth just £250 today.
Are you ready for that kind of risk?
A better option for most is to invest in a mutual fund or low-cost exchange traded funds (ETF), which may passively track hundreds or even thousands of small-cap stocks.
Mr Garnry names an ETF called iShares Russell 2000 for exposure to the United States. “This is the largest ETF tracking the US small-cap segment. ETFs have rock bottom charges, this fund has an expense ratio of 0.2 per cent. Vanguard Small-Cap ETF is even cheaper, charging just 0.06 per cent,” he says.
He also picks out the iShares S&P SmallCap 600, a London-listed fund that also tracks US stocks, and iShares EURO STOXX Small UCITS ETF. “Both ETFs have charges totalling 0.4 per cent, as it is slightly more expensive to get small-cap exposure in Europe than in the US,” Mr Garnry says.
From little acorns mighty oaks can grow. Apple was a smaller company once. So was Microsoft, Amazon, Facebook, Google and many other global corporate majors.
Sam Instone, the chief executive at the advisers AES International in Dubai, says for each of these global success stories hundreds of thousands fell by the wayside, but the dream lives on.
“In May 1997, Amazon floated at $1.50. Its current price is $941, so a modest initial investment of $1,600 would be worth $1 million today,” he says. There are exciting opportunities for investors with the time, knowledge and experience to research this sector. “The majority of institutional investors, analysts and wealth managers do not cover the small-cap market due to its smaller trade sizes and lower levels of liquidity. Those who do spend time researching the sector may therefore find bargains because there aren’t enough people looking for them,” Mr Instone says.
As well as offering higher potential returns, smaller companies also offer some diversification for your portfolio. “There will be periods when small-caps outperform, and periods when larger companies will dominate. Getting exposure to both sectors should give your portfolio better balance.”
Small-caps can also offer the potential for investment returns irrespective of the wider economic backdrop, he adds.
However, Mr Instone says you should only commit a small part of your portfolio and avoid being seduced by hindsight.“It is easy to look at what you could have earned by investing in a winner, while ignoring the losers.”
He also recommends using an ETF to provide broad exposure to a basket of small caps or a small cap index, to diversify risk.
In recent years many investors have shifted away from actively managed funds, preferring to follow the major indexes through low-cost trackers and ETFs.
This is a sensible move given that three quarters of managers typically underperform their chosen index, despite charging high fees that further erode your returns.
However, Patrick Connolly, a certified financial planner at Chase de Vere, says smaller companies is one sector where a top fund manager can still add value. “There is far less research on smaller companies, which means the best managers can find good opportunities and have a far greater chance of out-performing,” he says. “Because of this, we use active funds to get exposure to smaller companies, rather than trackers or ETFs.”
The very best actively managed smaller company funds have put in a startling performance over the past five years.
Baillie Gifford Japanese Smaller Companies has returned an incredible 190 per cent in that time, according to the figures from Trustnet.com. M&G Japan Smaller Companies returned 160 per cent over the same period.
In the North American sector, the T Rowe Price US Smaller Companies Equity Fund returned 146 per cent over five years, while Threadneedle American Smaller Companies and Schroder US Smaller Companies both grew nearly 140 per cent.
JPM Europe Smaller Companies grew 157 per cent over five years, while Lazard European Smaller Companies and Henderson European Smaller Companies both grew 150 per cent.
Most impressive of all, Old Mutual UK Smaller Companies Focus grew 207 per cent, more than double the average return for the UK smaller companies sector.
Old Mutual UK Smaller Companies grew 145 per cent and Threadneedle UK Smaller Companies grew 130 per cent. These are mind-boggling returns at a time when savings accounts pay just 1 per cent or less, but as ever, beware of the risks.
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