Why You Might Be Better-Off Investing In Small Caps This Year

By Tim Morris | More Articles by Tim Morris

Following the Global Financial Crisis in 2008/09, blue chip stocks were the place to invest your money. If you would have bought Commonwealth Bank (ASX:CBA) back in January 2009,you would have tripled your money by now and on top received fully franked dividends year after year. Not a bad investment at all. However, financial conditions in 2016 are much more challenging, especially given the high valuations of Australia’s leading blue-chip stocks. While many ‘large caps’ continue to pay attractive dividends and others seem to trade at reasonable valuations, capital growth opportunities appear somewhat limited. It is time for investors to diversify into small-mid caps stocks.

Small and mid-capitalisation companies have underperformed significantly during the bull-market of the past few years, however investors have shifted their focus in the past 12 months. The ‘Small Ordinaries’ index has outperformed the ‘ASX50’ in the past 12 months. The graph below compares the Small Ordinaries index with the ASX50 index, highlighting the outperformance of small-cap stocks over large-cap stocks since November 2015.

The question is: Will this trend likely continue and should investors look outside the ASX 50 for buying opportunities?

What are Small, Mid and Large Cap Stocks?

There is no universal rule that classifies companies into small, mid or large-caps, but we can roughly group stocks based on a number of characteristics.

Generally speaking, companies with a market capitalisation of more than $5 billion, established business operations and a history of consistent dividend payments are referred to as large-cap stocks. The S&P ASX 50 index gauges the performance of the 50 largest companies that are listed on the ASX. Any company with a market cap of less than $5-7billion (although there may be exceptions) is commonly referred to as a small or mid-cap.

Small Caps: A company is generally categorised as a small-cap stock if the market capitalisation is lower than $400 million. The S&P Small Ordinaries is the benchmark index that measures the performance of small-cap companies and covers roughly 7% of Australian equity market capitalisation. However, it must be noted that the market cap of companies included in the index may range from less than 10 million to several billion dollars. These companies are generally in their start-up or exploration stage and reliant on external capital.

Mid-Cap: In Australia, the term ‘mid-caps’ commonly refers to stocks with a market capitalisation of between $500 million and $3-5 billion. Generally, these companies are in their ‘expansionary’ stage, as they seek opportunities to expand revenues and increase their business scale in order to establish their presence in the industry.

What are the advantages of investing in small-cap companies?

Small-cap companies often have a higher growth potential as they are still in an early stage of their development. Simply put, it is easier for a $50 million company to double in value than for a $50 billion company. As these start-up companies grow their business, and institutional investors gain interest, their stock can rise significantly and investors who bought early enough into the company can enjoy strong returns. While this period is often considered to be the most ‘risky’ stage of a business, investors need to be aware of the risks and adjust their strategy accordingly. However, with higher risk comes often greater reward, which is one of the primary reasons why investors are interested in this space.

Crucial for success is a strong management team with a clear vision and an exceptional understanding of the industry as well as experience in capital markets. Management’s actions and decisions have a great impact on both the business and the stock and can potentially be the ‘quintessence’ for a company with a great product.

In times of elevated volatility, the stock price of small-mid cap companies tends to be dictated by the individual growth trajectory of the company, rather than the market as a whole. Admittedly the same applies for large caps stocks, however history has taught us that small caps with strong fundamentals are often less sensitive to general market volatility. If overseas markets fall overnight, investors tend to sell-down the ‘big banks’ first, but not necessarily their $30 million small cap with a bright long-term outlook.

Lastly, many small-caps are potential takeover targets for their larger competitors. The premium that is usually paid from the acquirer or the bidder can be very attractive for existing shareholders and is often one of the reasons why you bought this company in the first place.

Small Cap Investing in the Year Ahead

While there is obviously no guarantee for success – and past performance is no reliable indicator future performance – it appears that 2016 may be the first year in a while that could reward investors with exposure to the small-mid cap space. It makes sense to listen to the market and adjust your investment strategy accordingly.

Over the past few years, investing in blue chip stocks has been a great strategy to grow your wealth and we strongly advise to maintain significant exposure to this sector. However, we expect conditions to remain challenging which will likely result in subdued overall returns. There are plenty of portfolios with zero exposure to the small-mid cap space, and those who don’t make a move now will likely miss out on attractive opportunities.

Some small-mid cap stocks with strong fundamentals are for example technology companies such as Bulletproof (ASX:BPF), Mint Payments Limited (ASX:MNW), Freelancer (ASX:FLN) or Crowd Mobile (ASX:CM8). Currently at the lower end of the industry cycle, opportunities in the mining space are emerging. We favour Resolute Mining Limited (ASX:RSG), Medusa Mining (ASX:MML) or even Real Energy (ASX:RLE).

Tim Morris is Head Analyst at Wise-owl

Tim has conducted over 500 corporate valuations and appraisals, specialising in pre revenue assets and emerging markets.

Tim is Wise-owls specialist in equity analysis for Australian small and mid-cap companies across a diversified range of industries including resources, technology and financial services. Tim’s Equity Capital Market insights have been featured as part of a weekly column in The Australian, and regularly features on Sky News, CNBC, ABC, and Bloomberg TV.