Small caps are often overlooked due to perceived risk — but there are many advantages to participating in the sector, writes Vic Patel, head trader and analyst at educational site Forex Training Group.

Many people mistakenly believe that Small Cap stocks inherently trade at lower share prices than their Blue Chip counterparts. But the idea that Small Cap stocks are priced lower is a myth, and to clarify this, we must understand the concept of market capitalisation.

Market Capitalisation is calculated as the “Number of Shares Outstanding x Currently Traded Price Per Share”.

As you may notice from this formula, share prices only tell us a partial story about a stock’s value. The other part of the equation that must be taken into account is the outstanding shares.

Let’s take a look at an example:

Assume that a stock listed on the ASX is trading at $1 per share and has 200 million shares outstanding. The market cap for this stock would be $200 million.

Generally, we consider ASX small cap stocks as those listed companies that have market capitalisations up to about $400 million. (By comparison, in the US a small cap would be anything from $US400 million to $US2 billion).

There are many benefits to adding small cap stocks to your portfolio. Below I have listed 3 important reasons for investing in small cap companies.

1. Greater Potential Returns

Small Cap stocks tend to offer investors a higher return on their equity investment.

As many solid small cap companies are growing at a relatively rapid rate, there exists an opportunity to earn higher returns compared to large cap stocks.

These small cap companies can be more nimble in the marketplace because of their size, and they can often be first to market versus their larger competitors.

In addition, positive news and earnings related to these activities will be reflected more sharply in its share price.

With this added volatility, there will also be the potential for outsized losses as well. But the prudent small cap investor who understands and addresses these risks can be well rewarded for their efforts.

2. Hidden Gems in the Making

Head trader Vic Patel of Forex Training Group.

How would you have liked to get in on the ground floor with companies like Wise Tech Global, or Xero?

If you invested early enough in these companies, you would have a very healthy looking brokerage statement.

The point is that small and micro cap stocks offer huge opportunities for early investors.

If you are able to spot an emerging company that is positioning itself to gain a sizable percentage of market share in a particular niche or industry, it can pay off many times over.

This, however is easier said than done. You must be diligent in your efforts to undercover hidden gems in the market.

This is especially true of small caps since there is often little to no analyst coverage on many of these high flying stocks. But when you consider the risk to reward and potential payoff, the additional due diligence is often worth it.

3. Provides Diversification

It is of utmost importance that investors properly diversify their portfolios.

Anything and everything can happen in the share market. As such you have to protect yourself as much as you possibly can.

Many share investors tend to focus on larger well-known companies. These investors often feel more secure by doing this. But by adding small cap stocks to your portfolio, you can actually help smooth out your equity curve.

A well-balanced portfolio with a mix of large and small caps across various sectors can provide for better risk adjusted returns.

Finding Opportunities in Small Caps

Now that we understand what defines a small cap stock and why they can be advantageous as an investment vehicle, I want to shift my focus to discussing how I go about finding these opportunities.

The over-riding decision for me when it comes to looking for a potential small cap company to invest in is to ask the following question:

“Is this company the leader or runner-up in their specialised niche or are they creating a specialised niche”?

I am mainly interested in finding companies that are leaders or second within a specified sector or actually create a new niche within their industry.

This is the most important part of my analysis when it comes to selecting small cap candidates.

The reason that this is critical is that I have found that these types of companies can see extremely fast growth as they are often creating a completely new sub-sector of the marketplace.

A few examples that illustrates this conceptually that you may be able to relate with is Red Bull when it comes to energy drinks, Tesla when it comes to Electric Cars, or Uber when it comes to Ride sharing.

The second important consideration is a strong balance sheet with an adequate amount of cash on hand and a reasonable Debt ratio.

This requirement helps ensure that the company is financially healthy, and is likely to survive any unexpected downturns in the market cycle or other unanticipated adverse events.

So, we want to look for pioneering companies within a specialised niche or one that is creating a specialized niche, that has a strong balance sheet.

It certainly takes a good amount of time to find a handful of candidates that will meet these two criteria, but when you do find that, then you will be onto something special.

We want to find these opportunities before it makes sense for big institutional money to come in. As a small retail investor, we can be much more nimble in the markets looking for these types of hidden gems.

We want to get in before the institutional money does, because when they start pouring their money into these companies, we will typically start to see sizeable share price gains from their buying activity.

Final Thoughts

It should be clear from this discussion that the addition of small caps to your portfolio can add value to your bottom line.

Historically small caps have outperformed large cap stocks, and a reasonable allocation should be made available for them.

I have provided you my criteria for finding opportunities and investing in this sector. Whether that process aligns with your own personal style is up to you to decide.

But the most important thing is that you take some time to educate yourself about the small cap space, and apply some sound principles for share selection that align with our own beliefs about the market. The opportunity is there, you just have to find it.


This article was written by Vic Patel. He is the head trader and analyst at Forex Training Group, an educational website for new and aspiring traders and investors.


This article does not constitute financial product advice. You should consider obtaining independent advice before making any financial decisions.