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Why invest in small caps?

Small details can make a large difference to your portfolio returns.

If you view the small and mid cap part of the domestic market (essentially companies listed on the JSE, but outside of the Top 40 Index) as a separate asset class, a number of interesting observations can be made, particularly in the small cap space.

Firstly, most people are already invested in Top 40, blue chip and/or massive multi-national companies through their investments into pensions, unit trust and direct portfolios. If viewed through the lens of diversification, then most people are already over-weight blue chips and could use the added diversification from an investment into the lower part of the market, small caps.

Secondly, small cap shares (as well as their close cousins, mid caps) tend to outperform their larger, sluggish blue chip brethren (Figure 1). This is especially true over the longer-term when the higher day-to-day volatility of the small cap share prices becomes less relevant from a risk perspective.

Sources: Bloomberg, AlphaWealth workings

Finally, despite growing faster, small cap shares are relatively cheaper investments than the efficiently priced, highly traded and well- researched blue chip shares (Figure 2). Not only when measured by their price earnings (PE) but also when viewed in relation to their respective growth rates (i.e. the so-called price-earnings-growth ratio), small caps are generally cheaper than blue chips.

Sources: Bloomberg, AlphaWealth workings

Even more interesting, this portion of the market holds many more individual stocks for an investor to choose from than the forty companies in the Top 40 Index. An index is simply an average of a basket of stocks, but the underlying stock performances can vary quite widely. Thus, this expanded stock picking universe can lead to fantastic “ten bagger” opportunities (stocks that rise 1000%, i.e. making ten times your money on them).

To illustrate this, we did an exercise where we took only the top five performing stocks in each of small cap, mid cap and Top 40 indices and held them for ten full years (Figure 3). This would have turned an original R100 000 investment in the Top 40 into a R2.5 million investment today (which is nice), but would have turned the same sized initial investment in small caps into a whopping R7.7 million today (far better)!

In conclusion, while small caps do have liquidity, volatility and business risks attached to them, there is arguably a place for them in most equity portfolios.

Depending on your risk appetite, adding an allocation to small caps should add diversification to your portfolio while a careful selection (or, more likely, an allocation to a specialist small cap fund) has the potential to add significant upside performance to your long-term returns.

Sources: Bloomberg, AlphaWealth workings

Keith Mclachlan is a fund manager at AlphaWealth

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