Three Reasons Why Small-Cap Shares Can Be Promising Investments

It’s likely that there’re many local investors who feel comfortable investing in established companies, commonly known as blue chips, due to their perceived stability and familiarity.

In contrast, shares with small market capitalisations (market price of each share multiplied by the number of shares) tend to carry a bad reputation and are shunned. Some of the common negative associations that come with small-cap shares include being risky, lacking in quality, and occasionally, being outright frauds. The latter in particular, could perhaps be attributed to the many S-chips (China-based companies listed in Singapore) that were suspended from trading after being flagged up by audit reports or investigations.

Nevertheless, there are still several advantages related to investing with small-cap shares that can outweigh the associated negatives.

# 1 – Huge Potential of Growth

First and foremost, when investors look at companies with huge market capitalisations today, they forget that these companies had also started out as small businesses. In light of that, a small-cap share is basically a building block which offers new investors a chance to participate in its future growth.

Put another way, small-cap shares are like rough diamonds with the potential to become attractive, polished gems. And as the diamonds become polished, investors could then sit on long-term capital gains that could be several multiples of their initial investment. Osim (SGX: O23) and Ezion holdings (SGX: 5ME) are two examples of small-cap firms that have shown tremendous growth in the past to reach their current stage. The former carried a market cap of S$601 million 10 years ago and has since grown by 231% to a market cap of S$1.99 billion. The latter was worth a measly S$7.6 million in its entirety as a business but has since shot up by 33,400% in value to a market cap of S$2.54 billion.

Lastly, it is common sense that the larger a company grows, the slower its rate of growth could become. For instance, any company that has a $3 billion market cap would likely not enjoy the same potential to double as compared to a company with a $30 million market cap.

# 2 – Mutual Funds and Unit Trusts Commonly Do Not Invest In Small Caps Firms

Mutual funds and unit trusts often have an investing mandate that prevents them from investing huge sums of money in small-cap shares. Furthermore, a small percentage of cash inflow from a fund might cause a large swing in the share price of a company with a small market capitalisation as such companies simply lack the size to absorb big investments.

Such institutional restrictions could provide a great advantage to small or individual investors in the form of a lack of interest from the big boys. This can create buying opportunities for individual investors who are able to separate the wheat from the chaff within the small-cap universe and invest in promising firms early on at cheap prices.

# 3 – Small Caps generally go under the radar      

This point follows on from the last. Since institutional investors are often not interested or allowed to invest in small-cap shares, this lack of interest also spreads to the analyst community, resulting in small-cap shares seldom gaining much research coverage. This creates the possibility that small-cap shares, with great underlying businesses, may be materially undervalued. In such situations, investors have the opportunity to gain extra profits owing to pricing inefficiencies that occur.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor James Yeo doesn’t own shares in any companies mentioned.