As a general rule of thumb it makes sense to assume the market is efficient when it comes to larger stocks. But the smaller you go the more opportunities there are for private investors to make money. I consider small caps to be stocks with a valuation of below £250mn, but this is subjective. To an investor who looks at companies in the billions of market cap, a company that is only worth £1bn looks incredibly small.
The first reason almost all of my dealings are in small caps is because of their growth potential. Small-cap companies are often in the early stages of their growth cycle, so they have more room to grow compared with larger, more established companies. As a result, small-cap stocks have the potential to generate higher returns than larger-cap stocks, although they also come with higher risks. For example, many smaller companies can be reliant on external cash injections through the form of repeated discounted equity fundraises, so it’s always important to check the balance sheet and the cash flow statement of every company that you’re looking into to make sure there is: 1) enough cash in the bank; and 2) sustainable cash generation or a low burn compared with the cash position.
Smaller companies are often under-researched, too. Companies with smaller market caps are often not as widely covered by analysts and the media as larger companies, which means that there may be more opportunities to find undervalued stocks that the market has overlooked. Private investors who are willing to do their own research may be able to uncover promising small-cap stocks that are not yet on the radar of institutional investors. This is why many individuals are attracted to the smaller end of the market as well as the historical performance of small caps.
However, it's important to re-emphasise that small-cap stocks also come with bigger risks. They may be more volatile and have less liquidity than larger-cap stocks, which means that it may be harder to buy or sell shares at certain times. Private investors who are considering investing in small-cap stocks should do their own research and determine if these types of stocks are suitable for their investment goals and risk tolerance. The upside of this is the prospect of better returns. For example, a study by Ibbotson and Sinquefield found that from 1926 to 2019, small-cap stocks in the US had an average annual return of 11.9 per cent, compared with 9.6 per cent for large-cap stocks.
That said, it's important to note that past performance does not guarantee future results and there can be periods when small-cap stocks underperform. We’ve seen that this year with the FTSE 100 outperforming many of the major indices. Additionally, the performance of small-cap stocks can be heavily influenced by a variety of factors, including economic conditions, interest rates, and industry trends.
One final benefit of small-cap stocks is the diversification they can offer as they are uncorrelated to broader markets. Small caps are better masters of their own destinies, and so while many factors can influence them, management teams can be nimbler and adjust. Owning 10-15 stocks provides enough diversification but still plenty of upside in terms of potential growth.
One stock that I do believe has the ability to outperform the market over the coming year is Best Of The Best (BOTB). Best Of The Best is an online company that offers skill-based competitions where players can win their dream cars. You might have come across the company in airports and shopping centres many years ago but now the business is fully online. Looking at Chart 1, we can see the business benefited hugely from people having both more money in their pockets and more time due to lockdown. Naturally, people found a way to spend that money. However, the introduction of Apple’s iOS 14.5 caused a spike in customer acquisition costs, because it increased the cost of serving ads and made it harder to track them. The stock put out several profit warnings and ended up doing the Grand Old Duke of York back down to 400p.
However, moving across to Chart 2, we can see that the stock has now broken out of the 12-month range to the upside before pulling back. I’m long this stock and I’m looking to increase my position if its stock can break out of its recent high. With the company issuing £6.275mn in cash in a tender offer there are no concerns given its excellent cash generation.
The cost of living crisis may be a headwind for the company but while revenues were sharply down for the six months to 31 October, profits remained around a similar level as margins have been strengthened. After the attrition of customers acquired around Covid-19, management says the business is now ready for stable growth. Be careful, though – the stock is incredibly illiquid.
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