March 21, 2022

Investing Small For Big Potential

Skybound taking a closer look at smaller companies, discussing their pros and cons, and why you could consider investing in them.

They say the best things come in small packages.

What has this got to do with investing you might ask? There’s an area of investing that has often delivered higher growth than the broad stock market yet remains largely overlooked – smaller companies. They don’t get anywhere near the attention as the usual names that dominate stock markets like Microsoft, Apple and Amazon, but smaller companies have the potential to boost your investment returns.

In this article, we’ll take a closer look at smaller companies, discuss their pros and cons, and why you could consider investing in them.

What are smaller companies?

Although there’s no universal definition of what classifies a stock market company as small, if you order all companies by size the bottom 10-15% are generally considered to be the smaller companies, otherwise known as ‘small caps’. They’re not actually that small though. Although they come in many shapes and sizes, the average small cap company is worth over $1bn, and some can be worth tens of billions of dollars.

Where smaller companies outsize their bigger brothers though is in number – there are thousands and thousands of them. They come from the entire spectrum of industries, including technology, consumer, healthcare and financials, and though around half are from the USA, they can come from anywhere in the world.

Pros and cons of investing in smaller companies

Among smaller companies you’ll find some of the most cutting-edge companies out there, and the future stars of tomorrow. Remember all the largest, most successful companies were once small. Smaller companies have more room to grow than larger ones, which means they could deliver greater long-term returns. Over the long term that’s been the case, with smaller companies from the global stock market beating larger ones by a long way.

Graph showing 20 year performance of smaller companies vs global stock market
Past performance is not a guide to the future. Source: FE Analytics. Data in USD terms to 28/2/2022

Although there’s no guarantee of smaller companies performing better than the market, what they can guarantee is added variety to a portfolio made up of larger companies. By overlooking small caps, you’re shutting the door on thousands of opportunities that could help grow your wealth over the long term.

As with most investments though, you can’t have your cake and eat it. Although they offer the potential for outsized returns, smaller companies can be very volatile. They tend to fall further than the rest during market turbulence and can take longer to recover, as we’ve seen in recent months. That makes them more suited to more adventurous investors, who have the tolerance and time horizon to absorb that volatility.

Graph showing 6 month performance of smaller companies vs global stock market
Past performance is not a guide to the future. Source: FE Analytics. Data in USD terms to 28/2/2022

There have also been long stretches where smaller companies have lagged the broader market, including in recent years. It’s almost impossible for any investment to do well and beat the market all of the time, and it’s no different for small caps. They’re also less attractive to income-focused investors, as in general smaller companies pay lower dividends than larger businesses.

It can also be more difficult and time consuming to research these companies as they’re less well-covered by analysts and information on them can be harder to come by. Smaller companies’ shares are also traded less frequently, which means they can be harder and more expensive to buy and sell.

Our view

Given how many there are, and how much more difficult it can be to research them, we think investing in smaller companies is best left to professional fund managers with the skill and commitment to finding the best businesses. Small cap fund managers have a rich hunting ground of opportunities, and compared to larger company funds, have a higher chance of spotting hidden gems that could become the Apples and Microsofts of the future.

We think investing in smaller companies can add big benefits to portfolios, both to boost return potential and add more diversification. That’s why they feature in most of our investment portfolios. As they’re a higher-risk investment though, they feature more in our adventurous portfolios than in our balanced and cautious ones, and not at all in our most cautious portfolios.

The performance of smaller companies in recent months has undoubtedly been disappointing, but that’s nature of small-cap investing. There will be setbacks along the way, as there will be for nearly all investments. Over the long term though, we expect smaller companies to deliver strong returns for investors who can remain patient and stay focused on the big potential they offer.

Written By
Nikita Maxwell
Investment Analyst

Past performance is not a guide to future returns. Investment in securities involves the risk of loss and the advice herein cannot be construed as a guarantee that future performance will be reflective of past returns.

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