As a company gets larger, it may be tougher for it to continue growing. It’s for this reason that small cap stocks – companies that are of a smaller size now (both in terms of their businesses and their market caps) – tend to carry higher potential for future growth.
But, there are also important risks to note. So, let’s go through the opportunities as well as the dangers we may face when it comes to small cap investing.
To add on to my earlier description of what small cap stocks are, I like to see small caps as companies with a market capitalisation of less than S$500 million.
These companies are also typically less covered by analysts and thus many investors might not be familiar with them. Theoretically, this results in the creation of inefficiencies in the sense that small cap stocks with great businesses may be overlooked or remain undetected by individual investors and analysts.
This sets up the opportunity for attentive investors to pounce on hidden gems before they become more widely known. As the businesses of the gems continue to grow, these companies will gain higher recognition and that’s when the value of these firms gets realised.
Some firms which started out as small caps a decade ago and which have become big winners now include Super Group Ltd (SGX: S10), CWT Ltd (SGX: C14), Raffles Medical Group Ltd (SGX: R01), and Fragrance Group Limited (SGX: F31). (The quartet had carried market caps of lower than S$220 million each on 10 August 2005.)
Source: S&P Capital IQ
The growth in the quartet’s share price did not happen by accident – it came about due to a significant expansion in their businesses.
Source: S&P Capital IQ
While the growth in the quartet’s share price seem to be a great endorsement for the benefits of investing in small cap stocks, there are still risks to be wary of, like I mentioned earlier.
The small caps space is littered with potential fraud cases and companies with low-quality businesses. If you are not well-versed in the detection of aggressive accounting practices or downright fraudulent accounting, there’s a high possibility, in my opinion, of you ending up with the wrong stocks.
Another risk deals with business-risks; as small cap companies are still in their infancy, the odds of their success are uncertain. Anyone who’s trawling the small cap space for opportunities must be comfortable with making huge losses on a few individual stocks as not every pick will be successful.
Hunting for great investments in the small-cap pond can be exciting. It can even give you a great sense of accomplishment if you do get to unearth a real gem. But, we have to be aware of the risks before stepping into the pond – there might be hidden treasures, but do watch out for the dangerous crocodiles and predators.
There's a lot more to talk about when it comes to small caps investing and if you'd like to do so in person, you can come meet David Kuo and the rest of the Fool Singapore team on August 15!
The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Stanley Lim owns Super Group Limited.