Investing in small cap companies can be seen as a core strategy to achieving returns and wealth generation or a high-risk strategy that could also result in a lost investment.

The result of which all depends on the stock invested in and strategy used to pick the stock and of course in some cases it could just be dumb luck.

But why can investing in small cap companies be so lucrative?

1. Small cap stocks have more growth potential

When you think about it this is actual fairly obvious. A smaller company is likely at the beginning of its growth trajectory, whereas a larger company has likely reached maturity and in order to grow has to seek diversification into new products, offerings or markets.

But importantly, smaller companies can grow much quicker. Their ability to scale is far greater and it is likely they can sustain stronger growth for a longer period compared to their mature large cap counterparts.

It’s far more likely that a $100 million business can increase ten times to become a billion-dollar business than a billion dollar business increasing to a ten billion dollar one.

2. Under-researched can mean undervalued

Most small cap companies do not have a great deal of analysts covering them, and in the case of many they have none.

This may likely lead to a mis-pricing in small cap stocks–in some cases this could mean some are widely overvalued whereas others may significantly undervalued and pose a good investment opportunity.

This mis-pricing of small cap stocks can create opportunities for investors to take advantage of the inefficiencies in pricing to earn a return on investment when the market recognises the missing value and effectively re-rates the stock with a higher valuation.

3. Better engagement with investors

Management teams of small cap companies are in many cases more receptive towards investor queries and contact.

This could likely be because they generally have smaller teams, so you are more likely to get through to the top-dog, but it is more likely because small cap companies are focused on making sure the market and investors understand their business and what they have to offer.

The volume of people getting in touch will be far lower than that of an ASX100 stock and therefore the management will have far more time to dedicate to its investors.

4. More choice

There are 2,200 companies listed on the ASX – making 90 percent of the stocks on the ASX outside of the ASX200.

Small caps provide a much larger investible universe than the top 100 or 200 stocks.

Providing you are willing to do your research and start digging through the stocks, there are quite literally thousands of companies for small cap investors to choose from.

Your risk appetite will likely determine how far down the small cap spectrum you choose to dig.

5. Diversification, diversification, diversification

The large cap stocks are highly concentrated in mining and banking. By stepping outside of the ASX100 or 200 investors open themselves up to a much broader range of businesses and sectors.

Under the Radar Report recommends investing in 7-10 small cap stocks to diversify a small cap portfolio.

And with thousands to choose from it shouldn’t be difficult to reach the quota. The challenging and time-consuming part will be the research to determinine which stocks make it into your portfolio.

6. Aligned Management

Many small caps also have a management team who are the founders of the company. They can be far more passionate about the future of the business and its success than a CEO of a much larger company.

Many also have a significant amount of ‘skin in the game’ – having either invested in the business early on or taking a portion of their salary in shares.

This means that their interests are far more closely aligned to shareholders’ interests and they are also highly incentivised by the future success or the business.

But remember….

Small caps can be at the risky end of the investment spectrum and it is important to do your research.

Small caps can have trouble accessing capital or sources of financing required to achieve their goals and implement their growth strategies.

If the liquidity is too low, you may also struggle to get into the stock and to sell out.

They can also be more volatile – so you will have to be prepared to watch your investment fluctuate on a daily basis.

However, small caps offer some excellent investment opportunities if you are prepared to put in the leg work to discover them.

 

This content does not constitute financial product advice. You should consider obtaining independent advice before making any financial decisions.