Big profits from small companies
Small cap companies have their own unique characteristics.
Here are seven tips for profitable investments.
By Bertrand Beauté
"Investing in a big company is like driving a limo. It’s a smooth ride, but you don’t feel much," explains François Mollat du Jourdin, the chairman and founder of the multi-family office MJ&Cie. "With a small cap, you’re driving a go-kart. You know it can rattle a bit. You have to accept that risk." While small caps tend in the long term to outperform large caps, the road can often be quite a bumpy one. Here are a few tips to stop you from going off course.
1. INVEST OVER THE LONG TERM
Since the start of 2022, the MSCI Europe Small Cap index has lost more than 15% of its value (as of 31 May), while over the same period, the MSCI Large Cap index has shrunk by a more limited 5%. "Small-cap shares tend to experience market movements more acutely than multinationals," explains Raphaël Moreau, a fund manager at Amiral Gestion. "In periods of growth and optimism, they outperform the market. But the opposite is also true: during times of crisis and major uncertainty, they correct more sharply than big companies." Mollat du Jourdin agrees: "Small caps are the first to be affected during crises," says the MJ & Cie founder. "But they are also the first to bounce back when the economy takes off again. So you should invest in small caps during dips, just before the economy starts to recover." With markets falling since the beginning of the year, is now the perfect time to invest in small caps? "Current outlooks, in particular in light of the war in Ukraine, inflation and tightened monetary policies, remain highly uncertain. In the short term, I’m remaining cautious," replies Mollat du Jourdin. "But as a medium- or long-term investment, I would invest without hesitation."
2. STUDY THE COMPANY’S MANAGEMENT CAREFULLY
"Before investing in a small cap, we always meet the management," says Bart Geukens, portfolio manager for European small caps at DPAM, an asset management firm. "If we think there are management issues, we won’t invest. We’re looking for innovative, high-growth companies, but above all they have to be well managed." In the world of small caps, the quality of the management team is crucial. Compared to large groups, small companies are often managed and controlled by their founders. This means they tend to be led with a long-term strategic vision, where the influence of management is more direct and less diluted than it is in big companies. This situation is an asset, but it is also a risk: a poor strategic choice often has more severe consequences than in a large company. Hence the importance of properly analysing the quality of the management team before investing. "Small caps’ management teams are often more accessible than they are at large companies," says François Mollat du Jourdin. "This means that shareholders can establish constructive, productive dialogue with management."
3 PROFIT FROM MARKET INEFFICIENCY
Financial analysts prefer big market values. European companies with a stock market capitalisation of over $10 billion are generally tracked by 20 or more analysts. At the other end of the spectrum, it’s not rare to find that no specialist covers the smallest companies, whose valuation is no more than a few tens of millions. In France, for example, 30% of listed companies are not tracked. Why? "For the majority of companies with small market values, there aren’t enough trades to justify the cost of analysis," says Raphaël Moreau, Sextant PME fund manager at Amiral Gestion.
According to a study by Furey Research Partners, American large caps are tracked by around 20 analysts on average, with around 15 tracking mid caps, while small caps are covered by just five specialists. For investors, this difference in treatment can present an opportunity. Financial theory is built on the efficiency of financial markets, i.e. on the fact that the price reflects all available information. But in the absence of information, it may be the case that a share price doesn’t reflect the true economic value of the company. This situation leads to the potential for a share price to be undervalued or overvalued. "Investors can take advantage of these valuation anomalies," says Don Fitzgerald, a fund manager for European mid-caps at DNCA Investment.
4. ADOPT AN ACTIVE MANAGEMENT APPROACH
The world of small caps is much richer and more diverse than the world of large caps. The MSCI World Small Cap index features over 4,500 companies, while the MSCI World Large Cap has just 688. "For investors, being extremely selective and carefully choosing the companies to invest in is crucial," says Moreau, an analyst at Amiral Gestion. "The way to get the best possible performance is to only invest in the companies that perform best rather than investing via indices," Geukens adds. "Not all of the companies included in indices are necessarily to be recommended, and the largest companies are weighted more heavily than small companies. Investing in small caps through an index means you’re investing in yesterday’s winners."
5. INVEST IN WHAT YOU KNOW
Analysts track small caps less closely than large caps, and this is also true for the financial press. So how do you find out about small caps? "In the small business world, it’s not uncommon to see a complete lack of third-party research. It is therefore essential to speak directly to the company" believes William Cuss at Barings. Failing this, one can also delve into the annual reports. Guillaume Chieusse, head of small cap equity management at Oddo BHF AM, adds: "A few years ago, before investing in a Swedish small cap, we had to translate the company’s financial statements ourselves, because there was no information available in English!"
Painstaking work, but made easier by the fact that small caps tend to focus on targeted activities. "In my view, it’s easier to understand small companies than big companies, because they generally only develop a handful of products, which in turn are only available on a few markets," says Raphaël Moreau. "As an investor, it means you can know exactly what you’re investing in. With multinationals, which market hundreds of products worldwide, it’s much more complex. I recommend that private investors focus on a sector they know well, for example because they work in it. This can help them to identify companies that remain under the specialists’ radar."
6. ACCEPT THE RISKS
"Small companies generally have a more fragile business model than big companies that are already well established in their market. They are also less diversified, more sensitive to the quality of their management, and more dependent on a single product or geographical area," warns Bart Geukens from asset management firm DPAM. "This means that there is a greater risk of losing money when investing in small-cap shares compared to major companies. But the potential profits are also greater."
7. MONITOR LIQUIDITY
"The two main risks when investing in a small cap are volatility and lack of liquidity," explains Cuss, manager of the Small and Mid-Cap equity strategy at Barings. In essence, there are sometimes few sellers and few buyers for small cap stocks. This means it can be difficult to buy or sell a share at a given moment due to lack of supply or demand. The result is that a stakeholder who wants to exit the market can’t always do so immediately, unless they are willing to accept a cut-price sale. Lack of liquidity means that market movements are accentuated. And so while small caps aren’t, as a whole, more volatile than large caps, when taken individually, their stock market prices can be subject to heavy short-term fluctuations due to lack of liquidity. Before investing in a small cap, experts recommend paying attention to liquidity, taking note of volumes of shares traded on the markets and avoiding those shares for which very few daily transactions are made.