Small Can Be Great

Foreword from ShareInvestor

This article “Small Can Be Great” by Jonathan Kwok was first published in The Straits Times (INVEST) on 15 Jul 2012 and is reproduced in this blog in its entirety.

There is value to be found among small-cap counters but do be patient and diversify, say analysts

Small-capitalisation stocks may not be something that many investors look at but there could be winners among these firms, say analysts.

The stocks may, for example, be trading below their intrinsic value. The key is being able to separate the wheat from the chaff and being prudent with one’s investment capital.

Mr Terence Wong, head of research at DMG & Partners Securities, is a believer and he maintains a model portfolio of small and mid-cap stocks with market values below $1 billion. In the first quarter, the portfolio grew 24 per cent, outpacing the blue-chip Straits Times Index as well as the FTSE ST Small Cap Index.

“Choosing a small-cap stock is similar to choosing a larger stock,” he said. “First I look at the company and business, then the management team. If I like these, then I look at the financials of the company such as the balance sheet.”

He uses ratios such as price to book, price to earnings and dividend yield to value the stock, adding: “The company may be good but is the pricing attractive?”

One aspect that Mr Wong pays more attention to in smaller companies is management and corporate governance, as the risks of problems occurring in such companies can be larger than in blue-chip companies.

“These companies may be relatively young and there may be fewer internal controls,” he said.

There is no set definition as to what counts as a small and a mid-cap company and, in practice, the line can be blurred. Some analysts, like Mr Wong, consider stocks with a market value of $1 billion and below to be small-cap and “smaller-sized” mid-cap stocks.

Mr Roger Tan, chief executive of Sias Research, agrees that the factors to look at in analysing a company’s fundamentals are the same, regardless of its size.

“Ultimately, we are looking for companies that can generate returns at or above the cost of capital,” he said.

One risk with small caps, he said, is that they generally have limited resources and ability to acquire financing. This may lead to problems keeping afloat when the economy or the specific industry is facing problems.

“Due to limited resources, their strategies are not just about profitability but also survivability,” he said. Therefore, attention has to be paid to factors such as business strategy and the companies’ ability to find flexible financial arrangements.

When buying based on company fundamentals – analysing each company and buying stocks currently undervalued by the market – investors may have to wait for a long time for the price to appreciate to its fair value.

While some pay out attractive dividends, other companies may reinvest their earnings into growth opportunities, giving no immediate return to the investors. Patience is thus vital.

Less patient market players may choose to practise short-term trading. Here, investors buy stocks not based on the strength of the actual business, but on factors such as price momentum.

Before starting, it is useful to have an understanding of technical analysis and trading strategies.

“On the technical level, small to mid-caps tend to suffer from speculative cycles, making their share prices highly volatile,” said Mr Tan. “This means that traders have the opportunity to make huge returns but may suffer huge losses if the timing is wrong.”

Diversification is also vital when dealing with small-cap stocks. Remisier Gary Goh says that whenever he buys smaller counters, he does not sink in a lot of money in each stock and treats it as a speculative play.

“If you buy 10 small caps, maybe three or four will lose value, three or four may just stay there and there may be one or two that will perform well,” he said.

“If you have a higher risk tolerance, small caps may be a good idea. But no matter how confident you are of the company, due to its size, it tends to have a higher risk.”