Most investors would agree on diversification in a portfolio, and that asset allocation to equities across the market capitalisation is equally important. However, investors tend to overlook small caps in favour of well-established firms, those that are generally ‘too big to fail,’ and many would shy away from investing in small cap stocks as they are perceived to be riskier due to its volatility. While every stick has two ends, this article seeks to point out two reasons why small caps are often underrated in the world of investing.
- Opportunity for growth
Every company has to start small, and it is never an overnight success. It is far easier for a small company to double in size when compared to a large company. Large cap stocks are often the industry leaders, and generally do not represent the booming or emerging industries. Small cap stocks are often the new players that operate in new industries. By identifying small companies with strong moats that have the potential to speak for the next generation, investors can benefit as these businesses generate higher-earning growth rates and hopefully move up to the mid and large cap segment. Everyone talks about finding the next big thing, and if you have invested a modest amount of $500 on any blue chip stocks at the initial stage, it would have ballooned and made into a small fortune today.
- Lack of coverage
There are tonnes of resources out there as analysts evaluate and provide coverage over blue chip stocks like FAANG (Facebook, Amazon, Apple, Netflix, Google), WAAX (Wisetech, Altium, Afterpay, Xero), and BAT (Baidu, Alibaba, Tencent), but almost none for small cap stocks. The fact that regulations do not allow financial institutions to invest heavily in small cap stocks (part of it due to market liquidity) could be one of the reasons for the lack of coverage. We only have 24 hours in a day, and there is only so much an analyst can research on. Such lack of analysis would indicate an inefficient market in pricing the share price of small caps. But at the same time, this would also mean that it is unlikely for the stock price to be artificially pushed up due to large investments from major financial institutions.
Small caps are a mix of diamonds and duds, as not all small caps have the potential to come to fruition. A sensible investor might consider taking on more risk when investing in small cap stock, and only a few would risk an entire portfolio on small caps. While it is lucrative to think about making a fortune on a cheap small cap stock, know that it is not all about sunshine and rainbow.