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The value of small-company exposure in your portfolio

Date: 18/07/2022

As part of a diversification strategy, the inclusion of smaller listed companies in your share-market portfolio can deliver strong financial returns.

Given their phenomenal success, it is hard to contemplate that Amazon and Tesla were once small-cap stocks that escaped the attention of most investors.

In the case of Amazon, you could have snapped up shares in the company for just US$7 in 1998 – today it will cost you about US$109 a share. Tesla had a market capitalisation of just over US$1 billion in 2010 – it now sits at about US$724 billion.

Their success is a reminder that having exposure to small-cap shares can be a smart move. While most mum-and-dad investors in Australia focus on blue-chip equities such as the big banks and resources companies, these mature businesses cannot match the growth of a successful start-up, or rising star.

Small caps, big potential

In Australia, small-cap stocks are typically considered to be those that sit outside the ASX Top 100 companies and they generally have a market cap ranging from a few hundred million dollars to about AUD$2 billion. So, while they are still substantial businesses, they lack the scale and brand power of the blue-chip businesses.

Historically, global small-cap stocks have outperformed their large-cap rivals. At their best, they have the ability to double or triple in value quite quickly, whereas that is unlikely to happen with a big bank, for example.

With small caps, investors can get in on the ground floor and benefit from rapid growth as the business brings new products or services to a market, or creates a completely new market. The likes of Dominoes and Seek are Australian examples of small-cap stocks that have graduated to become mid-cap stocks – and along the way they have made a lot of money for investors who have stayed the course.

Diversification is one of the key advantages with small caps and, as part of a balanced portfolio, they can deliver strong but safe returns for many years. The owners of smaller companies typically put their own money into the business and, as a result, will do everything in their power to succeed. This can have impressive financial flow-on effects for investors.

Why you should exercise caution

However, it is important to make the point that small-cap stocks are not for everyone, and the truth is that small companies are more likely to go bankrupt than larger enterprises. This risk means that they are not typically recommended for investors with a conservative risk profile who may be better off investing in larger, more stable, companies. Whereas a big mining company can switch its export focus depending on market cycles, smaller companies usually have just one income stream. If that dries up, they can hit trouble – and their share values may plummet.

It is also worth noting that these small-cap stocks often have less liquidity, which in effect means there are fewer buyers than sellers. Consequently, it can be more difficult to exit a position at the market price.

Bank on trusted advice

Of course, for every Amazon and Tesla success story, there are numerous tales of small companies that disappear without a trace after initially being flagged as ‘the next big thing’.

The key is to buy stocks based on robust market research and the advice of experienced fund managers who know what is happening on the front line. Although research papers into small caps tend to be scarce, a good fund manager can help investors earmark stocks that appear to be on the rise.

A trusted financial adviser can also assess what shares an investor holds and make sure they do not put their money into too many risky equities. As a general rule, it is recommended that an investor should hold no more than 5% to 15% of small-cap equities in a portfolio, depending on a client’s goals.

So, the next time you discuss your portfolio with your financial adviser, ask them about small-cap stocks. They could be the growth asset you have long been seeking.

To find out more about investing in small-cap shares, speak to one of our Adrians Private Wealth partners.