Most discussions of asset allocation focus on the asset class level. This is not surprising as decisions about how much of a portfolio that is allocated to shares vs. Bonds and cash can have large influences on long-term returns.

However, allocations within asset classes can also influence a portfolio’s performance.
Within Australian and international equities, there’s differing risk and return profiles – it can be through market capitalisation – small cap has a different risk and return profile to large caps. With bonds, there’s treasury and junk bonds.

In an era where getting returns from equities feels like squeezing blood out a stone, many investors are looking further down the risk spectrum to get the returns they require.

Should investors take bigger bets on small caps?

What are small caps?

Small caps is short for small capitalisation, and refers to the size of the company’s market capitalisation.

What is considered small differs depending on who you ask. If you ask Investopedia, they believe that they are between $300 million and $2 billion. If you ask Morningstar, Small Cap can be defined as the stocks in the bottom 10% of the capitalisation of an equity market, or for tighter guidance, stocks under $800 million in market cap in the US market. If you ask Nasdaq, they believe it’s companies with a value less than $1 billion.

We love clean definitions, but ultimately an exact and universally accepted definition is not necessary. What we are really talking about is the inherent characteristics of small companies. A few million dollars in market capitalisation doesn’t really make a difference.

A small company is either one that has a product or service that is just emerging and has so far failed to gain widespread acceptance, a company that is serving a very limited market or a company that only has a very limited product range. It can also be a company that investors are very sceptical about. After all, we are talking about market capitalisation, which means if a company is trading at a very low valuation it could qualify as a small cap as well. None of these conditions are mutually exclusive - a small company could meet several or all these conditions.

The implications of these characteristics are what attracts investors and leads to the risks of investing in small companies.

Risks of small caps

The first is liquidity. Because it is a small cap, logically, that means that there is not as much trade volume coming in and out of the stock. The first hurdle is buying the stock, as the volume that you want to acquire may not be available to you immediately. The second hurdle is selling the stock, because there may not be enough demand from buyers to allow you to dispose of the investment.

Although historical trading volumes are not indicative of what will happen in the future, looking at this measure before you purchase your stock will give you some indication about whether it will be difficult to sell in the future. This means that small caps may not suit investors that foresee that they will need to access cash quickly from their investments.
What this lack of liquidity means is that there’s also volatility. Any decently sized trades can move the share price up or down. Smaller investors or a large investor interested in a share can move the market significantly.

Alignment with an investor’s strategy

This leads us to volatility. Volatility is not a friend to any investor that’s close to achieving their goals, or is drawing down on capital. This can often mean locking in losses or being forced to sell out of the investment at an unfavourable price. Volatility can also lead to poor investor behaviour because people get spooked. You need to ask yourself if you can withstand this volatility without resorting to behaviour that will ultimately lead to poor outcomes.

Income investors might avoid small caps. Although some small cap companies are mature, the majority are hoping to grow their business and operations. This often means that capital allocation focuses on internal or external growth opportunities, instead of distributing the capital as dividends to shareholders. Most small cap investments would not suit income-oriented investors that are looking for sustainable and consistent dividends.

Lastly, there is the opportunity cost of the investment. When you are investing, you are making a conscious decision about where to allocate finite capital. Choosing to invest in a small cap stock means that you are forgoing an investment with more certain earnings.

The reason that investors choose to invest in small cap stocks is the prospect for multiples of growth, which may or may not eventuate. When it does eventuate, the growth will be more accelerated and larger than an established, mature company. If it doesn’t eventuate, you’ve taken a risk on a company’s prospects instead of investing in an established mature company with a slower, but more solid growth trajectory. The upside is, though, because they are often not as well covered, there is more opportunity to find quality companies at lower prices.

The investor that may suit small caps

When you look at the risks – volatility, lack of dividends, liquidity, and risk that the company might not perform or even last, it is more of a list of what role they can’t play in an investor’s portfolio than who they suit.

At the end of the day, we need to step back from looking at small caps as investments and start to study them as businesses. If you are a business owner that has a small business, would you expect growth to occur overnight? What about in a year?

Ultimately, it is a question of moderation and time. As attractive as the potential for growth is with small cap stocks you need to consider whether you have a long enough time horizon to allow the potential for organic growth to play out. A study by S&P looked at the periods in which small caps paid off for investors for the risk that they took on. The study looked at 20-year total returns between the S&P Developed Ex-US Large Midcap, and the S&P Developed Ex-US Small Cap. Small caps have higher risk over three-to-five-year periods, but over a 10-20 year period onwards, small caps outperformed mid and large caps.

For investors with less than a ten-year time horizon to achieve their goal, small caps might not be the right subclass. For those with more than ten years, consider what you are trying to achieve with the investment.

Is it a quick hit of capital gains? The likelihood of this happening is not very high. Businesses do not evolve overnight, and if you are investing in a business because you expect it to go up overnight, that is most likely a speculative trade instead of investing.

Do you believe that the business has strong growth potential in a growing industry with a growing market? Does the business have savvy management making smart capital allocation decisions to foster growth?

This is where the moderation side of the equation comes in. Within your domestic or international exposure, ensure that you are using small caps as a supplement to the allocation to that asset class, instead of the main show.

There is also an argument that small caps have no place in most people’s portfolios. This theory basically suggests that you can adjust your portfolio in other ways to change the risk and return profile, without the volatility, lack of liquidity and income issues. A simple example would be to increase the Australian equities portion of your portfolio through mid and large cap and reduce the fixed income portion of your portfolio.

This argument works in theory but is not a direct replacement for small caps in your portfolio. It does not mimic the same risk and return profile, and it does not consider the typically lower valuations of small caps, the growth potential.

How to get exposure to small caps

We publish a study called the Active Passive Barometer. It looks at where active managers can add value by understanding the characteristics of the markets in which they outperform.
Generally, what we see is that they outperform in markets with large opportunity sets and inefficient markets that aren’t as well covered. For example, an emerging market economy could be where an active manager could add value. They may not be able to add as much value in a developed large cap market. However, there is a limit to this.

When markets get too broad and too large, active managers lose their edge. Where active managers are covering a single market (e.g. Australia), they are more likely to outperform passive managers, with their knowledge of the market, sector and industry dynamics. This edge gets diluted when you have an investment with multiple markets – for example, a global small cap portfolio. This is where passive funds achieve an edge. They generally have large holdings in small caps with higher market caps, covered by sell side analysts.

In this case, outperformance comes to scale, more than skill. The average active manager lacks the scale to deploy cross-sectional analysis weighing up both opportunities and threats at the global level across the different sectors and countries, putting them at a disadvantage relative to passive managers.

A passive fund doesn’t have stock-picking or risk-management flexibility, but it can compensate for this if it tracks a superior, well-diversified index that captures the opportunity set efficiently. Passive funds are usually also cheaper, which helps investors protect their total return.

Our highest rated small caps ETF

Our sole gold medallist small cap ETF is Vanguard MSCI International Smaller Companies ETF (ASX: VISM). The analyst notes that it has an unbeatable cost value proposition over active and passive peers alike, and it has highly efficient access to the developed market small cap stocks via an impressive diversified index.

As mentioned, the global small cap market is incredibly broad. It is rife with many risks that foster inefficiencies and has led to a wide range of outcomes. This would usually be a hot bed for opportunities for active managers, but it just hasn’t worked out that way. Again, the problem is scale, more than skill.

This is an important point to note and goes back to whether direct investments in small caps, especially international small caps, is achievable for an individual investor.

The answer may be that it is achievable, but it isn’t worth it. It would be a full-time job to actively manage and research a portfolio filled with international small cap stocks. This may be where a collective investment vehicle like an ETF or fund can help out.

Australia might be a little bit of a different story. Since Australia’s listed investment market is very small, if we look at market capitalisation, you can consider stocks 101-300 as small cap. This is exactly what the index S&P/ASX Small Ordinaries covers, and it accounts for 12% of the market here in Australia. Unlike the US, some of these companies are household names already, such as Kogan, or Lovisa, or Nick Scali.

Morningstar’s investment screener currently finds 30 undervalued Aussie small cap stocks (rated 4 and 5 stars)*. Morningstar subscribers and trialists** can access these through the premium investment screener.

*At 17 October 2023

**Take out a free, four-week trial. This offer is limited to new clients and cannot be used in combination with any other promotional offers and cannot be used to extend an existing Investor Membership. One free trial per household. Morningstar is licensed to provide our subscription service to Australian residents only.