The power of small caps

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Experienced equities analyst, stockbroker, financial journalist and founder of Under the Radar Report, Richard Hemming, discusses the power of small caps as a way for investors to diversify their portfolios.

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Ten years ago, nobody had really heard of Afterpay, and the buy-now-pay-later phenomenon had yet to emerge. Did people really know about electric vehicles, had they heard of lithium? Did people think that uranium-fuelled nuclear energy would be seriously considered? At varying times over the past decade, all of these options became available as small caps on the ASX, and investors who got in early made huge returns.

We define small caps as stocks that have market caps or valuations of less than $500 million. Essentially, these are stocks well below the biggest stock in the S&P/ASX 200 Index.

From years of investing and helping people build wealth from scratch, I know that investing in the right small caps at the right time can make the difference between average returns and phenomenal returns. Not only can investing in small caps be a good way to diversify your portfolio, but it can also be a good way to gain access to market disruption.

Why you are the most powerful investor you know

Many fund managers covet small caps. They covet them because, unlike individual investors, they have to buy them when they’re no longer “under the radar” and they’re in the S&P/ASX 200 Index, at which point most of the gains have already been made.

Thousands of people subscribe to our reports, only a small proportion of which are fund managers. The majority are like you and me, investing for ourselves. Why do we bother? We know the fund managers have dollar power. But what we have is the ability to be patient, to hold on, which trumps their deep pockets and aversion to short-term losses. The power of contrarian investing is greatest in small caps.

A good case study is Macquarie — the one you might not have heard of. It’s called Macquarie Technology, formerly Macquarie Telecom.

When I spoke to the company’s CEO David Tudehope in 2016, he was frustrated that his company’s transformation from a telecom reseller into a data centre and cloud operator wasn’t being reflected in its share price, which was too low in his view. Macquarie’s stock had traded stubbornly below $10 for years and Tudehope was promoting the group’s transformation when he said:

“We went to Melbourne and I was told that the shares will rally to much higher levels because fear and greed will attract the fund managers in the end.”

It was interesting that he said that, because at the time, fund manager Perpetual was putting pressure on the stock by selling out of its 13% holding. Why? Short-term bumps. After all, when you’re a fund manager you have to report to investors every quarter, so your pain threshold is low.

Macquarie had missed earnings targets because of its transformation. But ironically, after Perpetual sold out of its holding, Macquarie’s stock really started to improve. In fact, at over $70, the current share price is about nine or 10 times its mid-2015 level.

Macquarie had the right strategy and many retail investors like us held on and made big returns. Pushing the share price up were those same fund managers who are now back on the register, but at much higher prices.

Three big advantages of being an individual investor in small caps

1. You can put an investment in the bottom drawer and leave it there until the right time comes to sell. You don’t have to worry about quarterly performance, so you can wait and benefit from the turnaround in the company’s fortune.
2. You don’t need to hold as much stock (compared to a fund manager) to make a meaningful difference.
3. Compared to a fund manager, you don’t have to worry about being over-exposed to just two sectors. Australian fund managers often hold 40% of their portfolio in bank and resource stocks, because this is their weighting in the S&P/ASX 200 Index.

Of course, it should also be noted that compared to large cap stocks, small caps tend to have higher volatility and greater risk of business failure, so as with any asset class, do your research and invest at your own risk. If included as part of a diverse portfolio however, small caps can make a great addition.

Track your small caps with Sharesight

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FURTHER READING

• ETFs vs. stocks
• The pros and cons of dividend reinvestment plans
• How mergers and acquisitions affect your investment performance