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Small cap stocks investing in Singapore: Does it suit your risk appetite?

Stocks are ranked in order of market capitalisation, which is used to indicate the size and market value of a listed company. In general there are 3 main categories of market capitalization namely small cap, mid-cap and large cap (or blue chip stocks). While there is no precise market valuation range for a stock belonging under the small cap umbrella, the general consensus would be that stocks under small cap category have market capitalization of less than $500 million. Are small cap stocks really suitable for every investor out there in the market? This article will shed some key merits and pitfalls for small cap stocks.

 

Why do investors like investing in small cap stocks?

Some of the pros for buying small cap stocks include low P/E ratio and higher future growth via earnings increment and P/E expansion. Taking US stocks as an example, the small cap stocks universe returns can be represented by the S&P Smallcap 600 index which comprises U.S. companies with market capitalization between USD 450 million to USD 2.1 billion. Its annualized 10 year total returns as of 30 November 2017 stood at 10.4%, outperforming the bellwether index S&P 500 which consists of stocks with market capitalization exceeding USD6.1 billion, and generally comprises the finest large American corporations where 10 year annualized returns stood at 8.3%.

Selective investments into small cap stocks can potentially accelerate an investor’s financial goals and target returns over a period of 10 years or more. Historically small cap stocks have outperformed large cap stocks in terms of total returns via capital gains and dividends.

Small cap stocks are usually not heavily covered by analysts and media due to lower trading liquidity and volume. Institutional investors such as large mutual funds are restricted from buying small cap stocks due to low trading volumes and the inability to build meaningful stake for their portfolios. Hence the small cap stocks generally trade a low P/E multiples which gives retail investors an opportunity to accumulate the stock.

A small cap company with solid growth trend may turn out to be a multi-bagger where price trend higher as a result of P/E ratio expansion and higher earnings and dividends. Small cap stocks tend to be targets for acquisition and a premium may be realised depending on the investor. On the other hand, small cap companies may face difficulties going against their competition due to a smaller cash war chest.

 

If they have little analyst coverage, how can we tell if a small cap stock is performing well?

8I Education trainer Kelvin Seetoh gave ZUU Online a unique formula of evaluating small cap stocks

 

Management x ROE(Return On Equity) x Industry

 

“When we are analysing small cap companies, apart from the usual fundamentals analysis, the management is key to determine the long-term success of the firm. A founder-led business tends to be more visionary. They are hands-on, grounded and highly involved in the operations of the business. It also helps when their interests are aligned due to their significant shareholdings in the company. They are frugal too,” said Seetoh, raising the example of Walton of Walmart, Tony Tan Caktiong of Jollibee Foods, late Steve Jobs of Apple and Ma Huateng of Tencent.

“The most important financial metric for a small company is Return on Equity. This metric measures how much profit the company is able to generate per dollar of equity. Finally, we would need to see a company with a significant runway to grow in the industry. A company may not necessarily need to operate in a fast-growing industry in order to achieve that. A company can grow very well when it offers better products or services even in a slow growing industry.”

 

Do small cap stocks suit your needs?

Small cap stocks generally have different financial characteristics as compared to large blue chip stocks. For one, small cap stocks do not pay out regular dividends as most earnings are retained for business expansion. Hence, for an investor that relies on regular dividends for their daily expense needs, small cap stocks are not the best investment that provides an investor the stability of regular cash payouts. In general, investors who are in retirement or do not hold an active job should not allocate too high a percentage of their investment portfolio in small cap stocks. Small cap stocks have weaker balance sheet and higher gearing in general and equity could be wiped out in full should bankruptcy is filed. Hence investors who value capital protection such as retirees are not advisable to invest in small cap stocks.

Small cap stocks are highly volatile as well, where prices fluctuate wildly compared to large cap stocks with deep liquidity. Massive selling will drive prices down hard and investors must be able to stomach these price swings. Large downswings may be seen as an opportunity to invest more should there be no adverse change in fundamentals of the company. The risk measure for the S&P Smallcap 600 is higher at 19.6% standard deviation compared to S&P 500 at 15.08%. Investors wishing for a higher return may have to sit through higher price swings with a portfolio of small cap stocks. Investors should also avoid using share margin financing to fund their small caps purchase as huge price swings downwards may trigger margin calls which will push prices downwards even more.

More time and effort is needed to uncover hidden gems among the small cap universe. Financial ratios may not be readily available in presentable format and investors are required to conduct their own research into the financial reports filed with the SEC or stock exchanges. Immediate financial gains may not be realized as small caps are still in growth mode. Not all investors have the time and energy to conduct in depth research and compiling all the key financial data as they have a full time occupation and other life commitments. Information flow for small cap stocks lag behind large cap stocks.

 

Learn more first

Seetoh recommends investors learn more before taking the plunge, by attending talks like the one by Professor Hermann Simon, founder and honorary chairman of Simon-Kucher & Partners Strategy and Marketing Consultants, at the upcoming Value Investing Summit 2018. According to Seetoh, Simon would discuss how businesses can dominate a niche to build a sizeable and profitable market share, sustain profits by driving demand through value, build customer stickiness and a high switching cost into their business, and make their marketing effective for the global market.

“These are really good topics because all small caps stocks go through a phase where they prove themselves, gain customers adoption and scale massively on a global level. When an investor is able to pick a winning small cap stock early on, the financial returns are tremendous.”

 

 

This article first appeared on ZUU online.

ZUU online is an Asia-based financial education online portal. Founded in Japan by Kazumasa Tomita, a former private banker at Nomura Securities, the portal seeks to fill the information gap between institutional research houses and the private investor.

(By Chee Hoong Chan)

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