Mike Taylor: Smaller stocks offer fertile hunting ground for gems

When you think about it logically, it is no surprise that when measured as a group, smaller companies are more volatile than blue-chips. Photo / Getty Images

Opinion

Investing in small caps need not be a volatile experience, you just need to focus on the right stocks, Mike Taylor writes.

The major stock market indices around the world are almost household names these days.

Turn on the news and you are bound to hear about the latest movements in the Dow Jones Industrial Average, S&P 500, FTSE 100, ASX 200 and NZX 50. These indices comprise a collection of the largest companies listed on each stock exchange.

Less well-known are the "small cap" indices such as the Russell 2000, S&P Global SmallCap Index and ASX Small Ordinaries.

Many investors shun small cap stocks, putting them in the "too risky" basket. Indeed, the annualised volatility (a measure of riskiness) of the ASX Small Ordinaries since 2007 is tracking at 21 per cent, while the volatility of the ASX 200 over the same period is 19 per cent.

When you think about it logically, it is no surprise that when measured as a group, smaller companies are more volatile than blue-chips. Many of these companies are practically start-ups, yet to earn a dollar of revenue or prove their businesses economically viable.

In Australia, where I spend most of my time investing, many small caps are junior mining companies with little more than a licence to explore a plot of land for resources.

The share prices of these companies move violently with swings in commodity prices or markets, and ultimately their fates are binary outcomes - succeed or fail.

However, drawing conclusions about all small caps just because a bunch of them are incredibly risky is a mistake. Investing in small caps need not be a volatile experience, you just need to focus on the right stocks.

As an example, despite solely investing in small caps, all the funds managed by Pie Funds have been far less volatile than the ASX Small Ordinaries Index and even the blue chip-laden ASX 200.

So what's the trick to reducing volatility when investing in the small cap space? You will give yourself a huge head start by avoiding the volatile types of stocks described above.

Stay away from companies that point to the blue sky but lack a demonstrable track record of growth or momentum in the business.

Make sure to avoid speculative mining stocks despite the temptation that the discovery of a major resource will return double, triple or 10 times your original investment.

But by writing off all small caps as an asset class, you are ignoring a major growth engine of the economy. Remember that all the blue-chips had to start somewhere.

Small caps offer investors the opportunity to go along for the ride as companies grow from market minnows to industry leaders.

The small cap space also tends to be less competitive as an investment marketplace. This means you can find some extremely compelling opportunities before they appear on the radars of other investors.

Institutional investors, many of which manage billions of dollars and move markets with their buying and selling, are often unable to invest in small caps due to limited liquidity.

This means they are either unable to acquire enough shares to move the dial when it comes to their own investment returns, or their mandates prevent them from acquiring shares that cannot be liquidated with relative ease.

With these large market participants unable to invest in many small caps, there is little incentive for the analysts at brokerages and investment banks to produce detailed research on many of these companies.

The end result is more mispriced stocks when compared to the large cap universe, which is intensely covered by the analyst community and on the whole efficiently priced.

When it comes to the stock market, one man's loss is another man's opportunity. The fact that small caps are often overlooked creates a fertile hunting ground for those investors willing to spend the time and effort required to find hidden gems and hold them as they grow.

Finally, do not forget the importance of maintaining a diversified portfolio. Rather than going "all in" on a high conviction idea, maintain a portfolio of 10 to 15 stocks.

It is true that smaller businesses are at higher risk of a major event impacting its value. However by diversifying risk and focusing on the right type of stocks, your portfolio should be able to overcome this and deliver strong returns.

Mike Taylor is chief executive of Auckland's Pie Funds Management, which holds shares in Trilogy International and BWX.