Small company shares with big opportunities?

Keytrade Bank logo

Keytrade Bank

keytradebank.be

The stock exchange is a popular field for researchers. Barely a minute goes by without new insights, analyses and recommendations being published. Although many of these go by unnoticed, from time to time there are some insights that investors should take the time to read.

One such case was in 1993, when Eugene Fama and Kenneth French unveiled their study of the Small cap effect to the world. Their research revealed that since 1920, the smallest 10% of US companies had outperformed the largest 10% by an average of 2.4% annually. In other words, the smallest company shares (in terms of market capitalisation) have historically delivered higher returns. A few years after their groundbreaking publication, both authors were awarded the Nobel Prize for Economics.

Fama and French's findings have been repeatedly tested over the years and applied to other markets – and the superior performance of smaller companies could often (but certainly not always) be confirmed.

How small are small companies or small caps?

Small caps are listed companies with a relatively small market capitalisation of typically between around USD 300 million and USD 2 billion. Find out the difference between micro-caps, nano caps, small caps, mid-caps, large-caps and mega caps here.

What makes smaller companies attractive?

1. Greater growth potential

Smaller companies often have significant potential for growth. They are at an earlier stage in their life cycle and often develop innovative products or services that may go on to capture a large market. This potential can result in significant growth in the value of their shares, especially if the company is successful at innovation or entering new markets. Almost every large cap was once a small cap.

2. Less analysis, more opportunities

Compared to established major corporations, smaller companies attract much less attention from stock market analysts. This lack of coverage can result in undervaluations, giving investors an opportunity to invest in undervalued stocks before the rest of the market catches on. Small businesses are more likely to include some hidden gems.

3. Flexibility and adaptability

Smaller companies can generally respond more rapidly to changes in the market. Their small scale makes it easier for them to adjust business processes or implement new strategies. In rapidly changing markets, this flexibility can be a critical advantage.

4. Potential for acquisitions

Smaller companies are often acquisition targets for larger players. An acquisition can lead to a sudden jump in the value of the company's shares. This offers investors an opportunity for attractive returns, especially if the company occupies a promising niche or has developed critical technologies.

5. Higher dividend yield

In some cases, smaller companies offer higher dividend yields than larger companies. This is because they sometimes (have to) adopt a more "friendly" dividend policy in order to attract and retain investors.

6. Local exposure

Many smaller companies focus strongly on specific geographic markets, which can offer unique investment opportunities. Both logistical and geopolitical problems have once again raised the profile of short supply chains recently. By investing in these companies, investors can diversify their portfolio geographically, creating a better risk spread.

7. More diversification

There are tens of thousands of listed companies worldwide. While they only represent a small proportion in terms of market capitalisation, small caps are the largest group in terms of numbers. This diversity gives investors the opportunity to invest in a wide range of industries and niche markets.

8. Businesses that are easy to understand

One of the attractive features of smaller companies is their business model, which is usually simple and transparent. Unlike large, diversified conglomerates, whose business activities are complex and sometimes difficult to grasp, smaller companies are more likely to offer a clear and understandable product or service. This makes it easier for investors to appreciate the business dynamics and market potential. Investors are also more likely to have the opportunity to communicate directly with company management, something that is rare among larger companies. The management team members of smaller companies are often also major shareholder themselves, demonstrating a strong level of commitment.

9. Innovative players

Smaller companies are often the driving force for innovation within an industry. By investing in these companies, investors can be a part of innovative and potentially revolutionary developments.

What makes small caps more risky?

Although they have historically yielded higher potential returns, smaller companies also come with more risks.

Higher volatility

Smaller stocks often show greater price fluctuations. This is due to their limited liquidity, their smaller market capitalisation and the fact that there are fewer buyers and sellers, which can increase the gap between bid and ask prices. This volatility can lead to greater risks, especially in the short term.

Limited access to capital

Smaller companies often have more restricted access to capital markets. This can make it more difficult to grow or navigate through difficult economic times. In times of financial stress or market uncertainty, small businesses may find it harder to source funding, which can adversely impact their growth and stability.

Sensitivity to economic change

Small caps may be extremely sensitive to economic fluctuations. They often have a more limited customer base and are less geographically diverse, making them more vulnerable to changes in specific markets or sectors.

Limited track record

Smaller companies often have a shorter track record, making it trickier to accurately assess their performance and management capabilities. This lack of historical data can increase risk, as investors have less information available on which to base their decisions.

Less research and analysis

The limited coverage by analysts and less media attention are also disadvantages. The lack of analysis and research can make it more difficult for investors to reach informed decisions. Due to its size and complexity, this is a market that is difficult for individual investors and even institutional investors to grasp and understand in depth.

Concentration risk

Smaller companies often rely heavily on a limited number of products or services, making them more vulnerable to market fluctuations or changes in consumer demand.

Is now a good time to invest in small caps?

Small caps encountered a lot of headwind in 2023. While the MSCI ACWI Small Cap index[1] rose by just 2.61% last year[2], the MSCI ACWI[3] did much better at 10.1%. It was the raising of key interest rates in particular that caused this gap. The higher interest rates increase the financing costs for companies. Small caps, which are often more dependent on external financing and have a smaller financial buffer than larger companies, are affected more severely by this.

Higher interest rates also lead to tighter lending conditions, which particularly affects small companies with a higher risk profile. In addition, in uncertain times characterised by high interest rates, high inflation and a slowdown in growth, investors often tend to shift towards more defensive investments, such as large, well-established companies with strong balance sheets, making small caps less attractive. Finally, it was primarily larger, well-established companies that were in a position to jump on board such trends as artificial intelligence (AI) and the new potential of anti-obesity drugs in 2023.

We will have to wait and see whether 2024 will be a better year for small caps. Now that key rates have likely peaked, small caps could get some wind in their sails again. And temporary headwinds or not: small caps will always offer a long-term ticket for access to disruptive technologies and megatrends.

How can I invest in small caps?

You can invest in small caps through individual shares, a tracker (ETF), an actively managed investment fund or the like. Which of these three may be suitable depends, among other things, on your risk appetite, knowledge of the topic and how much time you wish to spend on your investments. Are you willing and able to take major risks? If so, shares may suit you best. If you are investing for the long term and would prefer a more diversified exposure, ETFs or actively managed investment funds focusing on small caps could be a potential solution.

Looking for trackers or funds relating to small caps?

  • Log in to Keytradebank.be on your laptop or desktop
  • Click on Advanced at the top of the screen, then ask to search by instrument name, symbol or ISIN
  • Tick Tracker and/or Fund
  • Search for the word Small

[1] The MSCI ACWI Small Cap index is a representative basket of 6,256 small caps from 23 industrialised countries and 24 emerging countries. [2] Period from 5/12/2022 to 4/12/2023) [3] The MSCI ACWI is a representative basket of 2,948 mid- and large-cap stocks from 23 industrialised countries and 24 emerging countries.

This article does not contain any investment advice or recommendation, nor a financial analysis. Nothing in this article may be construed as information with a contractual value of any sort whatsoever. This article is intended for information only and does not constitute in any way a commercialization of financial products. Keytrade Bank cannot be held liable for any decision made based on the information contained in this article, nor for its use by third parties. Every investment entails risks such as a possible loss of capital. Before investing in financial instruments, please inform yourself properly and read carefully the document "Overview of the principal characteristics and risks of financial instruments" that you can find in the Document centre

Other articles that might interest you