Investment sage Jim Slater once said that ‘elephants don’t gallop’ meaning that small companies have the capacity to grow much faster than big ones.
It is, for example, much easier for a £50m market cap to get to a £200m valuation than it is for a £50bn company to quadruple in size. Along with the capacity for growth there are several positives which come with investing in small cap companies.
A streamlined management structure enables most small caps to respond quickly to business opportunities and a niche focus can allow them to grab market share even when the size of the overall market is shrinking.
Many small cap companies have a strong innovative streak in contrast to their larger, more entrenched counterparts. The challenge when picking stocks is to determine if the market has got it right or wrong.
OVERLOOKED OPPORTUNITIES
If the market is right then the share price should reflect roughly what a business is worth. No market is entirely efficient though and the key is to look for situations where the market has priced a stock too cheaply.
Because many small caps will fly under the radar of big institutional investors and are generally less well researched there are probably more of these opportunities in this part of the market.
There are drawbacks too. Because, generally speaking, less people trade AIM shares it can be harder to buy and sell them. This lack of liquidity can mean there are significant bid/offer spreads on AIM stocks and result in bigger share price moves on a relatively modest amount of trading.
LIQUIDITY ISSUES
The offer is the price at which you can buy a stock, while the bid is the level at which you can sell in the market.
Small cap companies will often have greater exposure to a single product or service, can be overly reliant on their founder or chief executive officer and can be heavily exposed to one geographic region.
This means they have a less diversified revenue base and can be vulnerable to significant share price volatility in the event of macroeconomic shocks, technological change, management change or other unforeseen events.
In summary small caps offer scope for greater reward but at the cost of increased risks for the investor. You need to decide if this balance between risk and reward is appropriate for you and, even if it is, you should understand these risks properly before you invest.
