Our editor Richard Hemming discusses three steps to build a growth portfolio so that you get the benefits of investing in high growth Small Caps plus the long-term benefit of investing in the broad stock market.

Read more about Investing in Small Caps. Why we picked these ASX Small Cap gems and their outstanding performance.

Step 1: Diversification

To start you invest some money in something like a Vanguard fund or exchange traded fund (ETF) that tracks the performance of the index, giving you what the boffins call “beta”. The market is represented by indexes. In Australia’s case, the benchmark is most often the S&P/ASX 200 Index. An example of this “core” approach is investing in some 60 stocks, but the transaction costs would lampoon your returns. Achieving diversification is important, but not at any cost!

The best strategy is to invest in an index linked ETF or a Vanguard fund which replicates the index. Doing this achieves diversification at a low cost.

Step 2: How many stocks should you own?

The average return of the S&P/ASX 200 Index is close to 10% a year over the long-term, which you have covered in Step One with your ETF. Now you can consider owning some stocks for “alpha” or returns higher than the benchmark. Investors can use small caps to get this type of growth. I’m talking about ASX listed companies with market caps of less than $500 million. It’s much easier for a small cap to double or triple in size than a blue chip to achieve consistent double-digit growth. Of course,  the risks are higher.

The benefits of diversification ratchet up when you go from one to 10 ASX small cap stocks. After this the advantages diminish. Holding between seven to 10 ASX small cap stocks can be a reasonable starting point.

The advantages of owning small caps are clear. The “core” or “market” (in this case the S&P/ASX 200 Index) does not include these companies, so their returns are less correlated to the index. If the market down, some of these small caps could well go up, which lowers your overall stock market risk.

Also, because they are small, they have much more operating leverage, which is a big source of the above market growth they can achieve.

In terms of exposure to small caps in your portfolio, there is no one right answer for everyone because every investor has a different tolerance for risk. If you are risk averse you would put a greater portion of your funds in the core portfolio, for example. If you are able to embrace more risk, you may consider putting a bit less in the core and a bit more in your small cap portfolio.

Step 3: How to choose small cap stocks

Here is a quick checklist of what we look for in small companies at Under the Radar Report. We do all the hard work so you don't have to. Our expert team of analysts hunt the ASX for quality Small Cap stocks and bring new stock recommendations to subscribers every week. These are the Small Caps that our analysts believe offer the best risk/reward return. Join now to uncover this week's best stocks to buy and supercharge your future. 

1. Cash is King

• How much cash/debt does the company have compared to last year?

• What are the changes to its working capital?

• How much money does the company plan to invest?

• What is the company doing with its excess cash?

2. Sales growth

• Is the company growing sales?

• Why are those sales growing – volume or price rises?

• If it isn’t, what is driving earnings growth?

3. Margins matter

• How have costs changed over the period?

• What are the company’s input costs?

• What is the proportion of fixed costs to overall costs?

4. Be wary of what’s “underlying”

• What are the headline profits versus the so-called underlying?

• What has the company declared to be exceptional or one off in prior periods versus in the current period?

5. Outlook comments

• What is the tone of the latest outlook comments?

• Is the company looking to make acquisitions?

• Does the company have a track record of underestimating or overestimating future profit growth?

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