Small companies hold their ground

March 2022

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Entrepreneurs of small caps often turn their specific competencies into very healthy earnings growth. So it is most definitely worth taking a dive into the world of these small companies

Bart Daenekindt, fund manager KBC Asset Management

What are small caps?

Small but plentiful

Small caps are companies with a total stock market value of between 500 million and 3 billion euros. Companies with a stock market capitalisation of between 3 and 7 billion euros are referred to as ‘mid caps’, while those with a market capitalisation above 7 billion euros are referred to as ‘large caps’. 
Although the big players such as Apple, Microsoft, Walmart, and so on attract lots of media attention, we should not underestimate their small cousins, the small caps: between 80 and 90% of all stocks in the world are small caps.

Good liquidity management is vital

Large stocks are traded in vast numbers and are more liquid than small stocks, which are sometimes bought and sold in only small numbers each day. Their more limited liquidity can have a bigger impact on the share price, in response to both good and bad news. As a consequence, small companies are regarded as a riskier investment than large, well-known names. Good management and wide diversification are therefore crucial.

Actively seeking out hidden gems

Large institutional players are often unable to invest in small caps because of their more limited liquidity. These companies are therefore tracked by a smaller number of analysts. Those analysts who are skilled at tracking smaller businesses look for hidden gems. The big advantage is that the management of smaller companies is often much more accessible. The corporate culture and financial constructions are usually also simpler to understand. This makes the universe of small caps an ideal reservoir for active management.

1. Excellent growth potential

On average, small caps outperform the broad market over the longer term. The biggest driver of this outperformance is their higher earnings growth. Large companies have already had their growth spurt; smaller ones still have that potential. There are of course helped here by the law of large numbers. For a stock-market giant like Apple, for example, it is obviously not so easy to keep delivering double-digit turnover growth year after year.

Where does this potential come from?

Passionate leadership

Small caps are often led by a founder or their family. The management’s passion and commitment has a positive impact on the way the entire company works and the associated results.

Dynamic and innovative

Small caps are often created around a new product or service. They profit from new trends rather than being the victims of them. Companies which play a key role in the development and implementation of artificial intelligence are a good example of this.

Clear focus

The management of small caps generally maintains a clear focus, which means the company’s core activity remains at the heart of the business. This makes them interesting for investors wishing to play a particular theme. They are often world leaders within a small niche.

Agile

Their smallness of scale makes small caps agile and enables them to respond nimbly to changing market conditions. They do not have to burrow through several layers of management, as is often the case with large, established companies. Decisions can be taken quickly, and plans can be rapidly adjusted if need be.

Acquisition targets

Small caps are interesting acquisition targets for the big players, and that is especially relevant given today’s low interest rates.

2. Backbone of the economy

Small caps often receive scant attention in the media, creating the impression that the economy is powered by the large multinationals. Nothing could be further from the truth: worldwide, 80–90% of listed stocks are shares in small companies. The mass of small caps is the real engine of the economy.

Small caps are often also more focused on their domestic market, making them less vulnerable to a downturn in world trade or any further deglobalisation.

3. Economic recovery continues in 2022

Equity markets are sensitive to crises. The pandemic and associated lockdowns left their mark in 2020 and to a more limited extent in 2021. In times of crisis, small caps can lag behind large caps, partly because of their lower liquidity. Investors who are looking to avoid risk frequently turn away from small caps.  

Vaccination rates are high in many European countries, so the impact of a new wave on the economy seems to be less severe. Companies seem to be coping better with new variants. Small businesses remain in business and are reclaiming their leadership from the big players. When the recovery continues in 2022, they will benefit.

The war situation in Ukraine may have a temporary negative impact on small caps due to increased energy prices.

Did you know that...?

… … experience and research are the key elements for a successful selection of small caps. 
Investing in small caps is an interesting option because of their growth potential. As with everything, a higher potential return comes with strings attached: a higher potential return also means a certain degree of risk.

    Less liquid : Smaller stocks are traded less than shares in larger companies. This means executing orders can take longer, which can be a disadvantage if you want to sell your position quickly.

    More volatile : Lower liquidity automatically means more volatility in the share price. Wide price movements can present an opportunity, but can also be a disadvantage.

    Higher debt ratio : Many small caps have a slightly higher debt ratio, reflecting the extra investments that are needed to fire the business out of the starting blocks. It is a fact that every large stock began small, but it is an illusion to think that every small stock will automatically grow into a large one. There are enormous differences in quality. 

In order to strike a good balance between growth potential and risk, it is important to act from a position of knowledge. Active management and stock-picking absolutely make the difference in this field of investment. The trick is to pick out the high-quality smaller stocks and then buy them as cheaply as possible, before they become large and well known.

At KBC Asset Management you can rely on more than 15 years of experience. Our experts make a very judicious selection from the large pool of small caps. We go for companies which have a strong business model, good pricing power and high profit margins. The profitability on capital employed is our main criterion. Good diversification is essential.

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Redaction finalized 10th of March '22

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