Investing in Small Caps
Companies with a small market capitalization have many special features that can appeal to investors. Managers typically have a more entrepreneurial style and are more agile when it comes to responding to market demands and innovation trends. Such companies often attract buyers. Listed small-cap stocks are usually covered less extensively by financial analysts, and thus attract less market attention, which can make for attractive valuations. We believe a high-alpha investment strategy – one that involves managers skilled in benefiting from these features – suits this asset class best.
Investing in small caps allows investors
- To benefit from the growth of a company and help finance its development
- To tap into the often solid prospects for a company’s earnings growth resulting from a high degree of flexibility in creating value
- To gain exposure to domestic economic demand, while at the same time benefiting from accelerated global growth, renewed business confidence and, with regard to US small caps, tax reform.
Financing a company’s development from the ground floor up
Looking at the successive stages in a company’s development – 1. start-up, 2. growth, 3. maturity, 4. cruising speed and 5. recovery – small caps are generally in phases 1 or 2. At these points in their evolution, they typically finance investments externally. That leaves equity investors well-placed to take part these early stages that are usually associated with solid revenue and earnings growth.
Their growth prospects, financial needs and modest size also mean that small caps may be subject to takeover bids which can trigger instant spikes in their share prices. Our portfolio selection process does not specifically seek out companies likely to be targets, but, given the quality of companies chosen by our managers, takeovers can always happen.
A robust economic environment
These arguments support our conviction of the intrinsic value of investing in small caps. We believe the general economic environment is likely to remain robust for equities in 2018, assuming solid growth, moderate inflation and monetary policies that are still accommodative on the whole. Naturally, such an environment would benefit all market caps.
While renewed protectionism would be a threat to large-cap companies and their often high international exposure, there are other factors that favour small caps. Renewed economic growth in the eurozone, lighter US business and individual tax burdens, and the Trump’s administration infrastructure spending plans are examples of drivers of regional or national economies. These factors support robust domestic demand, which is often decisive in smaller companies’ success.
What sets our approach apart
Small caps are, on average, covered three times less by financial analysts than large caps. This is hardly surprising given the large number of stocks: 1 003 in the MSCI Europe Small Cap index vs. 445 in the MSCI Europe index, as of 31 January 2018. It offers opportunities for investment in undiscovered, underrated or underappreciated pearls. Our financial analysts closely follow all companies in our portfolios and are constantly on the lookout for new investment ideas, assessing companies’ fundamentals themselves and in one-on-one meetings with a small cap’s management.
Such a selective, high-touch investment approach suits this promising asset class best.