Small caps tend to be growth companies which have potential to yield a better capital return than bigger companies. However, there are additional risks associated with these investments. In this article we discuss the pros and cons, who is suitable, and when the best time is to buy small caps.

Characteristics:

Small cap stocks are usually companies that are younger. They are generally looking to grow their businesses at an accelerated rate.  Small cap companies have a market cap between $300 million and $2 billion and are often categorised as growth stocks.

Advantages/Disadvantages:

These are business in the growth phase so there is higher potential for capital growth. Small cap companies are usually domestically focused. This means that they are less affected by conflicts in international trade. These firms are not as stable as large cap firms and they do not have as much cash. As these businesses are in the growth phase, they may reinvest funds from earnings and not pay dividends to investors. There is also less liquidity in the stock market for small caps. Share prices of small cap stocks experience high volatility. This could lead to stock prices falling harder in bear markets. There is more risk in investing in small caps as companies are newer and are less established businesses. Small cap stocks are also reliant on external capital as their capital is limited.

Who is suitable:

Investors who are looking for capital growth who can take on risk would find small caps suitable. These investors may not need income immediately so can sacrifice income for capital growth. They also have a long investing time horizon to ride out the stock price fluctuations.

Best time to buy:

Small caps rise faster than large caps in bull markets. However small caps fall harder than large caps in bear markets. In market sell offs, small caps are the first to go as investors see these as riskier. Investors will see a lack of liquidity in small caps when there is a sell off. There will be a lot of sellers and not a lot of buyers which will drive the price down further. During recessionary periods, these are out of favour with investors and may go through a period of underperformance compared to larger cap stocks. When the economy is strong and there are higher levels of consumer confidence, small caps do well as people spend money with less constraints.

Lauren Hua is a private client adviser at Fairmont Equities.

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