Why small caps are less risky than their bigger counterparts

Many people I meet say, “Oh, small caps, they’re too risky!” I nod and walk on. Small Caps do move a great deal more than their larger ASX shares, I admit. When the Australian finance news reports Telstra had a big day, declining 3 percent, I think to myself, that’s nothing! Double-digit falls and for that matter rises, are almost de rigueur in small caps, which I define as an ASX listed company with a market cap of less than $500m.

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

Diversification and holding ASX shares that complement each other

When you focus on small caps as a whole, you are forgetting that the major advances in reducing risk from investing have been through diversifying that risk, which means holding ASX shares that complement each other, otherwise known as reducing correlation.

Because the big companies represent the market, in order to produce more consistent returns, you need to purchase ASX shares that are off the beaten track so to speak. In stock market parlance, they call this “low beta”.

How to generate big returns from ASX Shares?

Generating exposure to the stock market through an index fund provides the cheapest form of diversification, but if you want to reduce your risk further, and generate bigger returns, ASX shares that have a low correlation to the market are worth thinking about.

Before I get to some of these ASX shares, it’s important to point out that every ASX share is going to have a correlation coefficient of at least 0.5, which means the influence of the ASX share market is 50% or more on its price movement. If an ASX share has a correlation coefficient of 1, it moves in line with the share market. Conversely, if it’s -1 it moves in exactly the opposite direction.

You don’t want to pretend that an ASX share’s behaviour is going to be separate from the market, although through history there might be the odd incidence of this. What you have to do is be careful in selecting ASX shares that won’t behave like the share market, which to my way of thinking includes those shares that are not expensive.

ASX Shares that look cheap

Certainly, two ASX shares that have looked cheap, the junior nickel producer Small Cap Panoramic Resources (PAN) and the sleep apnoea specialist small cap SomnoMed (SOM) have both spiked 40% plus in recent weeks, the former on a takeover bid from ASX share Independence Group (IGO).

Small Caps under takeover offer: Panoramic Resources (PAN)

For an ASX Small Cap like Panoramic, it’s not a diversified producer and has had significant problems resuscitating its Savanah Mine in the East Kimberley region of Western Australia. Consequently, its shares hadn’t moved despite a buoyant nickel price. It recently raised emergency capital to keep the Macquarie creditors from its door. Independence swooped. Name a big cap taken over recently? I can name three or four small caps.

Small Caps: in a turnaround phase

ASX small cap SomnoMed like so many small caps is undergoing a turnaround, this one due to some serious strategic missteps. Hence it was cheap. The ASX Small Cap med-tech is also part of an industry going through a secular growth trend – the treatment of sleep apnea. It has been attempting to tap into this demand and has recently woken investors up through its success in the US market.

Small Caps: Medical Stock on the move

Another Small Cap medical stock I have mentioned often in this column is Medical Developments (MVP), producer of the famed Green Whistle. This company is tapping into demand from around the world for affordable non-opiate based analgesic pain relief.

Small Caps: Strong demand

Then there is the shipbuilder Austal (ASB). This ASX Small Cap company’s earnings are less correlated with the market because of its long 20-year-plus purchase cycle. It is unlikely to be affected by month-to-month variations in consumer demand.

Small Caps: Give ASX investors great Shares to Buy

The ASX is a very concentrated share market from a market capitalisation perspective. Share investors have great opportunities to look at its long tail in order to diversify their portfolios and gain access to ASX shares that move independently from the BHPs and NABs of this world.

Oh, and the next time I’m told about the riskiness of small caps I might offer them the Green Whistle.

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