Small-cap investing

Small-cap investing refers to investing, or buying shares, in smaller companies, with the aim of watching them grow and generate a return on your investment. For this reason, many refer to it as ‘growth investing’, as the value of the company will, hopefully, continue growing throughout the duration of your investment. If, for example, you buy shares in a small-cap for £5 a share and the company doubles its market capitalisation, you could be able to sell your shares for £10 each.

The likelihood of this is influenced by a number of factors, and investors must be mindful of the possibility that the company could lose money, just as easily as it could increase its value. Small-cap investments are high-risk and are usually more volatile and illiquid. It is not always easy to sell, and they can fall further than the wider market. Growth is not guaranteed, and these companies are more exposed to fluctuations in the domestic economy. They are not, therefore, suitable for all investors.

Smaller companies do not refer to micro businesses, like a local coffee shop or clothing boutique. They can in fact be well-established market leaders, household names, popular expanding companies or those known for finding a niche in certain markets. The reason they are classed as smaller companies refers to their relatively small market capitalisations, i.e., the value of the company as it is traded on the stock market, which is calculated by multiplying the total number of shares issued by the current share price. A general rule of thumb is market capitalisations (or market worth) of between £100m and £2bn. This may not sound small, but when compared to companies such as Apple (US$2.70trn as at 03 October 2023) or Microsoft (US$2.329trn as at 03 October 2023), you can see the relative scale.

Smaller companies, therefore, are referring to those that are:

• Listed on AIM – companies listed here can have a market capitalisation above £2bn.

OR

• Have a market capitalisation that is less than £2bn and is not within the FTSE 100 – this includes companies within the FTSE 250, FTSE Small cap and FTSE Fledgling indices.

Investing in small-caps can offer superior returns and growth and they have historically outperformed large-cap stocks. They are however more volatile, and higher risk, so having a specialist by your side is a good idea.

There are a number of benefits to investing in small-caps, including:

Growth:

Compared with larger organisations, small-caps grow much more rapidly, which is in turn more likely to be reflected in the value of your investment. Large organisations take a long time to double in size, whereas growth by 25%, 50% or even 100% is much more commonplace amongst small-caps.

Initial Public Offerings (IPOs):

If a privately owned small company is then listed on a stock exchange (such as AIM), it offers investors an opportunity to increase the value of their holding (although this isn’t always the case, as some companies devalue after their IPO).

Mergers and acquisitions:

Smaller companies are prone to more takeovers within their community given their accessible size. In contrast to larger companies, small-caps are more likely to buy their competitors, or be sold to them, which in turn has the possibility of creating opportunities for investors to increase their holding value.

Strong positions in niche markets:

Small-caps often satisfy a very specific need within their market. These markets can either be mature, smaller, and isolated from disruption (large-caps usually do not justify the cost of entry into niche markets), or they are rapidly expanding small markets which have not captured the attention of a bigger operator in a related field. A great example of this is the gaming sector in the UK – a hugely growing sector within small-cap investing.

Ability to roll out business plans:

These are companies that are in the process of rolling out a product to new markets, either store by store or in phases, and have a proven and successful offering.

More tech in UK small-caps:

The small-cap sector contains a significant quantity of tech stocks, whilst there is a real dearth in the UK large-cap market, despite technology being the growth story of recent years (examples being Facebook, Amazon, Netflix, to name a few).

The best investment for you will depend on your personal situation and appetite for risk. The aim is to achieve a balance that is right for you.

Whilst small-caps often relate to growth-investing, this is not always the case. Investors are looking to gain from the trajectory of a company’s growth; if the value of a company increases, so does the value of its shares.

Large-caps, on the other hand, often relate to ‘quality investing’ or income investing, although again, this not always the case. Investors make money from the companies they invest in paying out their shareholder dividends.

Small-cap investing is generally classed as risky as:

1. Larger organisations are generally thought of as safer than smaller companies –because they are less likely to go bust
2. Small-caps are known for their volatility – whilst their growth can be rapid, so too can their decline
3. Smaller companies are also far less liquid than larger companies. They often have far less cash, as this is usually invested in future growth, so investors cannot always liquidate their investment (i.e., take their cash out) as easily as they could in larger companies
4. There is also often less information available about smaller companies (they attract less media and analytical coverage than their larger counterparts), so investors are required to gather  more information to know what they are investing in. It is for this reason that investing in a small-cap fund is seen as a safer option than investing directly in smaller companies – you can utilise a fund manager who is more likely to be an expert.

The amount you should be investing in small-caps is wholly dependent on your personal circumstances and proportionate to your appetite for risk.

If you are approaching retirement, or are already retired, you are likely focused on becoming an income investor (making money from dividend payouts from the companies you invest in) and will have a lower risk tolerance.

Younger investors, on the other hand, generally plan on investing for a long time to come or have a large amount of investable capital to begin with. This lends itself to a higher tolerance for risk and places them in the category of growth investors (buying shares at a certain value with the intention of selling them for more).

If this category of growth investing and higher risk tolerance resonates with you, you could look into the possibility of allocating more of your investments to small-caps. Ultimately, however, it will depend on a number of personal factors, so speak to one of our expert Wealth Managers before deciding what is right for you.

A good time to consider investing in smaller companies usually falls after a period of slow growth, when economies are emerging from a recession. These smaller companies usually enjoy periods of rapid growth at this time, and investors are therefore likely to see returns on their investments more quickly than at other points of the economic cycle.

Another good opportunity for investors is market corrections. When a market drops in value after a period of volatility, it can offer a good buying opportunity for investors. When the market inevitably rises again, so do the value of their investments.