A few months back, I read an article about small cap stocks are doing far better than large caps. . If one is able to pick a good small cap or large cap company at reasonable valuations, then over a longer period of time, his portfolio is bound to give a higher return than the one consisting of only large caps.
In fact, according to Ibbotson Associates, a firm that tracks long term data (of companies listed in USA), small caps have increased in value by an average of more than 12% per year between 1927 and 2007. Meanwhile, large caps have increased just over 10% during that same time period. A difference of 2% per year compounded annually can make a huge difference to the end value of his portfolio.
Well, this performance advantage is no coincidence. In fact, small caps have several advantages that large caps simply can't match. They being :
Temporary Valuation Disconnect
Small caps may outperform larger companies over time, but the operative words here are "over time". That's because smaller companies, primarily because of their lack of visibility within the investment community, often experience a disconnect between their stock prices and their fundamentals. This discrepancy between price and fundamentals presents a tremendous opportunity that small cap investors can take advantage of.
Thin Market
Small caps tend to be thinly traded and, while this is a characteristic that can slice both ways, it often presents a huge opportunity for shrewd investors. As the company grows its revenues and earnings over time and the public becomes more aware of its existence and future growth prospects, demand for the stock inevitably perks up. And when a large number of investors start to clamor over a very limited amount of stock, this gives small cap stocks the potential to rise quite rapidly.
Lack of Analyst Coverage
We all have observed, that how various analysts keep track of earnings of large cap companies. They keep making estimate about future earnings of big companies(although they mostly fail), but no one cares about small cap companies and their earnings potential. The analysts start tracking such companies only when they have already grown by 40-50 times. Thus, if one jumps in early into a small cap company at its nascent stage, a lot of money can be made.
Institutional ownership
You must have often observed in our reports, that most of the stocks recommended by us, do not have any holding of major financial institutions or mutual funds. Well this scenario proves to be quite beneficial, as it can present a huge opportunity particularly for investors who get in early. Later on when major financial institutions start investing, then there happens P/E expansion for such companies, thereby giving good returns.
Adaptability
Eric Schmidt, who headed up Novell (Nadsaq:NOVL) and later moved on to Google (Nasdaq:GOOG), once said in a conference call that big companies were like aircraft carriers or cruise ships, "they take a long time to change direction."
In many ways, this is a perfect analogy. In fact, it can take years for a larger company to bring a new product to market because of the committees that need to review its practicality (before its introduction), the legal vetting it must receive and the work that goes into its marketing and promotion. Also the impact of a new product on overall earnings of the company, may not be that substantial. Small companies, on the other hand, have less bureaucracy and a genuine need to push products to market just to survive.
Thus there are numerous factors, which make small cap companies, a suitable investment option, if researched properly.
In fact, according to Ibbotson Associates, a firm that tracks long term data (of companies listed in USA), small caps have increased in value by an average of more than 12% per year between 1927 and 2007. Meanwhile, large caps have increased just over 10% during that same time period. A difference of 2% per year compounded annually can make a huge difference to the end value of his portfolio.
Well, this performance advantage is no coincidence. In fact, small caps have several advantages that large caps simply can't match. They being :
Temporary Valuation Disconnect
Small caps may outperform larger companies over time, but the operative words here are "over time". That's because smaller companies, primarily because of their lack of visibility within the investment community, often experience a disconnect between their stock prices and their fundamentals. This discrepancy between price and fundamentals presents a tremendous opportunity that small cap investors can take advantage of.
Thin Market
Small caps tend to be thinly traded and, while this is a characteristic that can slice both ways, it often presents a huge opportunity for shrewd investors. As the company grows its revenues and earnings over time and the public becomes more aware of its existence and future growth prospects, demand for the stock inevitably perks up. And when a large number of investors start to clamor over a very limited amount of stock, this gives small cap stocks the potential to rise quite rapidly.
Lack of Analyst Coverage
We all have observed, that how various analysts keep track of earnings of large cap companies. They keep making estimate about future earnings of big companies(although they mostly fail), but no one cares about small cap companies and their earnings potential. The analysts start tracking such companies only when they have already grown by 40-50 times. Thus, if one jumps in early into a small cap company at its nascent stage, a lot of money can be made.
Institutional ownership
You must have often observed in our reports, that most of the stocks recommended by us, do not have any holding of major financial institutions or mutual funds. Well this scenario proves to be quite beneficial, as it can present a huge opportunity particularly for investors who get in early. Later on when major financial institutions start investing, then there happens P/E expansion for such companies, thereby giving good returns.
Adaptability
Eric Schmidt, who headed up Novell (Nadsaq:NOVL) and later moved on to Google (Nasdaq:GOOG), once said in a conference call that big companies were like aircraft carriers or cruise ships, "they take a long time to change direction."
In many ways, this is a perfect analogy. In fact, it can take years for a larger company to bring a new product to market because of the committees that need to review its practicality (before its introduction), the legal vetting it must receive and the work that goes into its marketing and promotion. Also the impact of a new product on overall earnings of the company, may not be that substantial. Small companies, on the other hand, have less bureaucracy and a genuine need to push products to market just to survive.
Thus there are numerous factors, which make small cap companies, a suitable investment option, if researched properly.
To contact the Lead Associate on this story: Ekansh Mittal in Noida (New Delhi) at Ekansh@hbjcapital.com
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