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Small Caps: Why you need to invest in Small Cap Shares?09.04.2014

What are small caps? And why you need to invest in small cap companies.

There are risks in any investment, but when you are paying very low prices for assets that have relatively big potential, there is less that can go wrong if there are hiccups. You can have many of these small cap stocks in your portfolio and a lot won’t do anything. But for the ones that do, it will be worth the ride. Small caps help you generate growth.

Why do you need to invest in Small caps?  Small Caps offer above average growth

The share market goes up and down, but historically it tends to rise more than it falls. This occurs in seven out of ten years. If you average out its returns, you are looking at about 10.5% a year. And your timing has to be good to generate this return, and even over a number of years.

To generate the sort of wealth to fund your retirement needs you need to do better than this: you need to hit the ball out of the park on one or two investments. This is what Small Caps can do.

What are Small caps?

The term small cap is bandied about a lot because many fund managers want to be associated with a part of the market that signifies above average growth. The reality is, however, that the definition many use stretches the concept of a small listed company.

Fund managers often say that a small cap is a listed company outside of the S&P/ASX 100 Index. This means that many companies they invest in have market capitalisations of greater than $1 billion.

There are 2185 listed companies on the ASX and the median market cap of the 200 biggest as at 30 June 2013 was $1.8 billion. But it’s in the long tail small cap shares where most action is for shareholders looking for better than average returns.

Almost 90 per cent of these companies, numbering just under 2000 have market caps below $300 million.  It’s these companies that this column classes as Small Caps, and for these companies it is normal for there to be few announcements other than to report profit numbers.

How have Small Caps been performing?

In the 12 months to the end of June S&P/ASX 100 Index of the biggest companies by market capitalisation outperformed the S&P/ASX Small Cap Index by nearly 30 per cent. It was up about 15 per cent compared with the Small Cap Index’s negative 11 per cent. This was due principally to investors hunting for earnings certainty and dividend yields.

Over half of the S&P/ASX 100 Index’s return last year came from three of the four banks, Telstra and the pharmaceutical company CSL.

More recently, it’s a different story. Since 1 July, the Small Cap Index has climbed 17 per cent to the end of last month, compared with the top 100 Index, which has risen 9 per cent.

The big reason is in our opinion is bargain hunting. There is genuine value at the smaller end of the index, and particularly in mining and mining services. Remember that even after a recent bounce, the Small Resources Index is still down 65 per cent over the past year.

The metals and mining services stocks represent about 20 per cent of the Small Ordinaries benchmark but are trading at very cheap levels. The average PE of these stocks is about five times and if these stocks climb by 50 per cent, it means their average PE is re-rated from four times to 7.5 times.

High-priced industrial stocks such as Austbrokers would have to be re-rated from PEs of 16 to 24, just to keep up, which seems unlikely.

Growth is the key for small cap success

Another factor is that right now, people are in love with dividends, but it is earnings growth that is the key to making money. Small Cap companies do not have the luxury of paying out all their earnings in dividends like some of the big companies do. This works out to the investors’ advantage, however.

It is always important to remember that it is the movement of share prices, not the dividends paid, which dictates the returns investors make, over any period of time.

From 2000 to 2012, the return from Telstra’s dividends was 73 per cent, but its price return was -47 per cent. It delivered a measly total return of 26 per cent over this whole period.

Companies only grow when profits are reinvested, and when a company’s sole objective is to maintain a high dividend yield, it doesn’t augur well for long-term value.

Compare Telstra’s return with the gold producer, Newcrest Mining. The miner delivered an average annual dividend yield of 0.78 per cent between 2000 and 2012 with the annual dividend increasing from 5 cents in 2000 to 35 cents in 2012.

An investor that bought Newcrest in 2000 would have achieved a total return of 406 per cent in 2012, comprising a 363 per cent price return and a 43 per cent dividend return.

Small Caps: information is hard to find

There is risk in buying small caps. But there is risk in buying any investment, especially in the stock market.

Stocks like the banks, Telstra and some internet companies are trading at record high levels because investors perceive that there is relatively high certainty that their earnings will appreciate, delivering growing dividend income. These companies have high “price risk”. If there is any softening of their earnings growth, their share prices are extremely vulnerable to big falls.

In contrast, what you see with Small Caps, is “information risk”. In these companies their historic earnings performance can often bear little resemblance to their future earnings.

Under the Radar Report helps solve this “information risk”for small caps

The small cap companies Under the Radar Report covers and advocates buying are often not covered anywhere else. Fund managers are often not interested in them, because they are too small and it is hard for big funds to get a meaningful stake.

Under the Radar Report adopts a proprietary investment process in order to look for Small Caps that match our criteria. In addition to analysing company announcements and financials, we spend a great deal of time speaking to the management of the company.

Under the Radar Report also gives its subscribers’ access to professional investors’ thoughts – both on the market in general, and what they’re buying and selling.

If you want an edge in your portfolio, subscribe to Under the Radar Report. It’s the best investment you’ll ever make.

 

 

About the Author

Richard Hemming

Investment analyst and Editor of Under the Radar Report

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