In small cap investing (U.S., international, emerging market, and global small cap) there are exploitable inefficiencies that are less available in large cap. Read on to learn more about some of the opportunities and challenges in this space.
Earnings revisions: In the large cap space, companies are typically covered by many sell-side analysts that are all forecasting earnings for a company. As one hypothetical example, Apple might have 40 or more analysts forecasting its earnings. Some may revise their forecasts over time, but the likelihood of a single revision moving the stock price is low. Also, with 40+ forecasts, it’s difficult for a (buy-side) investment manager to gain an information advantage with so many sell-side analysts covering the company.
In small cap land, a company is often covered by just one or two sell-side analysts (and sometimes will have no coverage at all), which offers greater opportunity for an investment manager to have a differentiated view. If one of two analysts revises their forecast it can have a meaningful effect on the stock price. Better yet, if there is no sell-side coverage, the investment manager is working off of their proprietary forecast. This inefficiency is just one example of how having fewer eyes on a company can lead to an information advantage.
Other Small Cap Considerations
Local exposure to a developing consumer: There’s a global theme of the “emerging consumer,” mostly in emerging markets. Small cap companies tend to serve these consumers. If you want to play the “emerging consumer” theme, small companies will make up a good part of that exposure. (When you look at the U.S., EAFE, or EM, the small cap indices have larger allocations to the Consumer Discretionary sector versus large cap.)
Supply chain: Investing in a supply chain as opposed to an end product offers unique opportunities. For example, if you like smart phones, do you buy Apple or Samsung? Why not buy a component supplier that sells to both? It could be a more reliable play on smart phone growth and you don’t have to know whether Apple or Samsung will “win,” as long as one of them does well. Suppliers can be smaller cap.
Higher growth rates: If an investor seeks significant capital appreciation, small caps can offer it — but beware, there’s a saying in small cap that “you either grow or go out of business.”
Simple companies, and lots of them: Small cap companies tend to be simple, often offering a single product or service. Investors who like to understand the companies they buy might find smaller companies appealing. There are also more stocks to consider. Of the 8,600 stocks out there globally, over 6,000 are small cap.
Risks
Although small cap investing can offer outsized performance potential, it usually comes with higher risk. Small cap companies typically:
- Are higher beta than large caps (higher volatility)
- May have higher default risk
- Frequently are headed by a founder who might have a great product or service idea but less experience running a business
- Tend to need financing, and special attention to the capital structure is warranted
Read our 2017 Capital Market Projections to see our 10-year forecast for various asset classes.
