The growth potential in small cap investing is significant, much more so than in the FTSE 100. But it is considered the riskier end of the investment spectrum, due to the fact that the companies are smaller.
The coronavirus crisis has tested the mettle of companies large and small. But what has become apparent, is that large parts of the FTSE 100 have become the market equivalent of Jurassic Park, housing the dinosaurs of former glory. And covid-19 is the asteroid that has sent many of them hurtling, if not into oblivion, then the FTSE 250.
Comparatively, companies outside the FTSE 100 look more like the tiny mammals, poised to inherit the earth. When we talk about small cap investing, we mean companies that are listed on AIM (Alternative Investment Market), or have a market capitalisation of less than £2bn, including companies in the FTSE 250, FTSE SmallCap and FTSE Fledgling indices. And because of this breadth, as a universe, small and mid-cap stocks are more interesting.
For a start, there is the diversity in small caps – technology, healthcare, on-line gaming, consumer discretionary (non-essential goods) – that we just don’t see in large caps. FTSE 100 companies tend to be concentrated within a limited range of sectors, which can lead to greater risk as companies within one sector tend to move in the same direction (think of what’s happened to oil and gas this year). So the range in small caps gives better opportunities to diversify a portfolio effectively.
The primary upside benefit of small cap investing is the growth potential – small companies can theoretically grow at a faster rate and by a greater ratio than mid or large cap counterparts. They benefit from the law of large numbers – it’s easier to multiply the size of a £100m company by 10, than to grow a £100bn company to a £1trn company. Another plus is that smaller companies are more likely to be acquired, as their size makes them easier to snap up by larger competitors – and acquisitions can signify a payday for investors.
But with the upside comes the downside and inevitably, with these benefits comes the risk. In the past, the small cap sector has been labelled the ‘Wild West’ of investing, because the smaller the company, the more likely it is to go bust. And they do fail more frequently than their larger counterparts, which obviously means investors can lose their money. They can also be illiquid, meaning they can be difficult to sell exactly when you want to. They are also not attractive if you are an income-seeking investor – they tend to re-invest profits back into the company, rather than pay dividends as larger companies might.
When we look at the small cap vs large cap argument against the backdrop of the current environment, things haven’t panned out as we would usually expect. In a downturn, there tends to be a flight to quality companies, which historically get equated with large cap. But this economic crisis hasn’t worked like that – and many stocks that have traditionally been defensive stocks (e.g. the integrated oil companies and banks) have struggled in the pandemic world.
So these days, investors need to be smarter. covid-19 is rewriting the rule book. If you are an investor who likes the UK market, then small and mid-caps – due to their growth potential – might be worth a look. However, it helps to know what to look for within the sector:
- Niche businesses: are companies that satisfy a really specific market need. It tends to be a smaller, mature market that is more isolated from disruption – the markets are usually small enough that large caps wouldn’t justify the cost of entry. This might be a company such as AB Dynamics, a supplier of integrated test systems for the global automotive industry. Or Creo Medical, a medical device company focused on the emerging field of surgical endoscopy. Gaming is also a big growth sector within small caps with companies like Games Workshop, a manufacturer of miniature wargames figurines.
- Roll-out stories: these are companies that have a proven and successful offering and are in the process of rolling their product out to new markets, either in phases or store by store. For example, if it’s a shop, the cash flow it generates can be used to pay back the initial investment and to pay for new shops – as the number of new outlets expand, central costs are spread out across more shops, which increases the margin and the roll out rate can accelerate – the valuation of the company increases and so the process continues. When a roll out story works, it can be highly beneficial for investors – think Hotel Chocolat, the British chocolatier and coca grower that has over 70 stories in the UK. Or Cake Box, a personalised egg-free cake business with 114 stores nationwide.
- Market leaders: this is another interesting story in the small cap sector – market leaders are companies that carry the largest market share in their peer group. Some interesting examples are: online clothes retailer, ASOS; pizza delivery company Dominos; or Marshalls, the leading supplier of materials for garden design and construction.
- IPOs (initial public offering): this is always an interesting area for investors who have the opportunity to ‘get in early’ with a company – companies engaging in an IPO are raising initial capital to help them transform from a private company to a public listed entity. Some examples of successful recent IPOs include: global eyewear company, Inspecs; or Watches of Switzerland, a leading luxury watch specialist in the UK that is also expanding into the US.
- Industry consolidators: another interesting theme in small cap investing, is where companies buy up their competitors and improve them – sectors where there are opportunities to consolidate are always attractive to investors. Some companies include: Keywords Studios, a global service provider to the video gaming industry, or leading UK regional law firm, Knights.
It’s probably fair to say that small cap investing – the AIM market in particular – has shaken off its Wild West tag in recent years, predominantly down to the success of tech and gaming companies and high profile growth stories, like Fever-Tree. But it can still be a minefield – who would have seen the issues at Patisserie Valerie coming? That’s why it’s really important for investors to tread carefully, get informed and not go in all guns blazing.
Further reading: AIM market performance beats mainstream indices