Investing in smaller companies

The media and Hollywood constantly sell us the idea that investing in smaller companies is dangerous, risky and even foolish – but I think differently.

The recent 'Wolf of Wall Street' is a classic example. ‘Rich people don't buy penny stocks … because they're too smart', says Jordan Belfort. In the film ‘Boiler Room’ a broker bullies a client into investing all his savings into a small speculative stock, which subsequently collapses.

Smaller companies, or small caps, may not be appropriate for everyone. They are more volatile than their larger peers and less liquid, meaning they can be harder to sell. Small caps also usually fall further in a market sell-off. However, historically, they have performed better over long periods, even on a risk-adjusted basis.

Many investors, particularly those planning to invest for a very long time, should consider gaining some exposure to smaller companies. Diversification is especially important when investing in small-cap stocks and the best way to achieve this, in my opinion, is through buying a fund rather than buying stocks individually.

So Why Do Small Caps Outperform?

The biggest reason smaller companies outperform is that it is easier for them to grow. It’s much easier to grow profits from £1 to £2 million than from £1 to £2 billion. Smaller companies are more likely to go bust, but they also have the potential to increase three, four or more times in value, something which it is very difficult for mega-cap companies to do.

The easiest way for the mega caps to generate greater profits is to buy other companies. And this is another reason why small caps outperform. The large mega caps are rarely taken over for a premium like their smaller peers. The smaller a company is the more potential buyers it has.

The final reason small caps outperform is simply because they are riskier. There are fewer investors willing to accept the volatility of small caps and, as a result, investors demand a higher rate of return to own them.  

Of course there is absolutely no guarantee that small-caps will always outperform, and they often go through very long periods of underperformance versus their larger peers, which is why it is especially important to have a long-term investment horizon. AiM stocks (Alternative Investment Market, which is made up predominantly of smaller companies), for example, have had a torrid time of it lately. Small and mid-caps have done much better than larger-cap stocks over the past few years, but some commentators now think they look relatively expensive. Indeed, mid-caps stocks, which had very high valuations, have pulled back in the past few days.

Small Cap Funds

I am not suggesting investors should only hold small caps, only that they should consider having some exposure to them. As I said earlier, it is very important to diversify your small-cap holdings to remove the stock specific risk. One of the best ways to do this, in my view, is through buying a fund which invests in many different companies. Avoid getting caught up in the hype and excitement and the get-rich-quick schemes, depicted so well on the big screen, and let a professional manager research the companies and do the stock picking for you.

By James Yardley, senior research analyst, Chelsea