Small Cap Investing Risk Reward

I currently hold a portfolio consisting solely of small cap companies for one reason; they are better value than anything else I can find.  I have a theory about why this is and this theory is that when it comes to investing to make more money than the market average you need to invest in something that is undervalued, for example a company that will grow faster than expected.  For it to be undervalued you really need to know something about it that others don’t.  

If you were to invest in a company that was among the top 100 on the stock market you would be investing in a company that a lot of people would be familiar with.  As a result, you would have to query how much edge you would have over other people investing in such a company.  Invest in small company, especially one which requires a detailed analysis and you’ll find that many of the larger investors will not be that interested so you’ll be competing with a smaller group of people for a good price.  As a result, on a complex small cap you often find there are opportunities for an investor who is willing to do their homework to gain an edge over fellow investors.  It is this edge that will allow you to invest in a company that you can be confident is undervalued.  If you’re analysis is good enough, you should also be able to consider the potential associated risk and hence only invest if its risk is less than that of a larger firm.

When it comes to large firms there are two key points that are often forgotten: firstly it is hard for a large firm to experience much exceptional growth and secondly it is a myth that large firms do not go out of business.  In the past there have been occasions when one of the top 10 firms in the world has highly valued on the basis of ‘potential future growth’.  Now, there are big companies that have maintained impressive and unrelenting growth, take Coca-Cola as an example, but these are exceptional cases which have been exceptionally well run; the odds of growing one of the largest companies in the world into an even bigger company are fairly slim.  On the other hand the odds of growing a small cap company into a large one are far better, because all those top companies were once small caps and if you had a crystal ball that could spot those that will be big in the future, you’d be exceptionally successful.

There is, however, one area where the small cap loses out and that is when things go wrong.  When this happens to a big company they either shut the division down or use profits from other divisions to ride it out.  For a small cap a similar problem could wipe the company out.  As a result, you have to be prepared to lose it all on a small cap.  Fortunately, the gains can often compensate for this and if you get your homework right this should be unlikely.  As a result, my opinion on small caps is that if you’ve got enough ability to spot a good company and if you do your homework to ensure it should ride out any potential future issues, then you can make more money for less risk, but if you don’t know what you’re doing, you’re probably best sticking to big firms.  Why less risk?  Because if you buy something undervalued, you can be pretty sure that the price is going to go up.