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INVESTMENT: Paying Attention to the Small Cap Space
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Paying Attention to the Small Cap Space

By Michael Dow

BT 201605 51 InvestmentCategorising stocks by the size of the company's market capitalisation - a fancy term which simply describes the value of a firm's outstanding share - has become very popular. Nowadays people talk about investing in small caps, medium caps, large caps and even giant caps but, in the end, does it really matter? Of course, in a general sense, the size of a company's market cap or the amount of assets on its balance sheet, and so on, are no match for the quality of its products or services and its prospects for future growth.

However, there are some trends that we have to consider when it comes to evaluating the merits of investing in larger or smaller market cap companies. The most important thing to bear in mind is that the adjective placed before the 'cap' shapes people's perceptions of how risky an asset is. When one thinks of a large or giant cap company there is a tendency to conjure up images of the world's biggest players in a given sector. This includes Apple INC, Microsoft, Exxon Mobil Corp, Johnson & Johnson, Coca Cola and all of those household names that enjoy a fairly dominant and consistently profitable existence. Investors associate these big boys of the corporate world with stability and safety as they have the economies of scale, the global presence, the brand recognition and the track record of success that continues to entice people to buy their stock through the good times and bad.

The so called "small caps" on the other hand - generally defined as firms whose market capitalisation is somewhere between USD 300 million and USD 2 billion - don't tend to have such a favourable reputation. Because many of them are still relatively unknown to the average person on the street and because their balance sheet is nowhere near as huge as those of some of the aforementioned companies -- they are usually associated with higher levels of risk. It certainly doesn't help their cause when so many financial experts publish books about how people can get rich quick by gambling with penny stocks and start-ups.

With this in mind it is easy to see why so many investors miss out on great opportunities because they simply don't pay enough attention, if any, to the small cap space. The fact that small caps are so overlooked is in itself a great reason to start browsing in this area. There are literally thousands of incredibly young companies out there that are just waiting to be discovered. As more investors stumble upon these hidden gems over time it will push up the share price and provide the companies with much needed working capital which could potentially be used to fuel even faster growth.

BT 201605 50 InvestmentLooking at it from a boring old mathematical perspective, small caps often look to be much better long-term prospects for investors who are seeking capital appreciation. That is because small companies grow from a smaller arithmetic base. It is easier to double sales of a USD 10 million company than sales of a USD 10 billion company. Small companies are often in growing industries and find it easier to change their strategy in response to market conditions. These firms are also often run by their founders or a small group of managers who are more motivated to increase shareholder value. These incentives are what really give people who get in early the bang for their buck in the longer term.

It might be a great idea to ride Warren Buffett's Berkshire Hathaway gravy train but one individual share will cost over USD 190,000 at today's price. Small caps are attractive to individual investors because they are comparatively cheap to get involved in. If you are only able to invest a few hundred or perhaps a couple of thousand dollars per year towards building your financial fortress then it is easy to accumulate a sizable amount of shares in a company while it is still young than cash out later when the valuation has increased substantially.

One of the cases often put forward to deter people from investing in small caps is the possibility that there may not be enough people willing to buy stocks and therefore it reduces one's ability to cash out when the time is right. While the lack of liquidity in small caps is a valid cause for concern that should be taken into account, it also greatly increases the chance of market inefficiencies working in our favour. Because few, if any, brokerage firms cover small companies, there is a greater possibility of market inefficiencies. Because most small companies have relatively few shares freely trading, a liquidity problem exists. This liquidity problem prevents many large institutions from investing in these companies. This reduces the number of buyers for the stock and can cause the stock price to be unjustifiably low. Conversely, when a large buyer tries to buy an illiquid stock, the price can go up dramatically. This inefficient environment works to our advantage: we are able to accumulate the undervalued shares and hold on to them for the long term. A small company that grows and performs well will ultimately draw more attention, increasing trading volume and driving up valuation.

BT 201605 51 Investment hlIt is worth pointing out as well that small and medium cap companies are more often the targets of lucrative acquisitions. If a firm is doing well in a particular industrial sector but one of the bigger players realises that it will be a very beneficial addition to their corporate portfolio then they may well try to snap it up. If the small cap is still performing well at the time when a bigger firm buys them out then one can expect to receive a good return on their investment when the transaction is complete. Ideally it will be such a gem of a company that several big players are taking an interest. That way the bidding war that inevitably ensues will drive the value of the small cap's shares through the roof.

Right now it is a good time to start looking into and buying up small cap equities. In terms of pure GDP the global economy isn't really improving all that much but it is important to bear in mind that new industries, new opportunities and new markets are emerging at a faster pace than ever before. Not only do individual investors have more access to information about the rising stars of the small cap space, they also have better access than ever before to global equity markets. In sum, there are more golden opportunities in this area than ever before and now is the time to start hunting for bargains.


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