Investing in Small and Mid-Cap Stocks
Investing in small and mid-cap stocks can be profitable, exciting and help you to diversify your portfolio. Read below for a full guide about small-mid cap stocks, advantages and risks and some useful tips on how to analyse these high growth companies.
What are Small and Mid-Caps?
Whilst there is no regulated definition as to which companies classify as small or mid-capitalisation stocks, there are a few guidelines that help determine if a company belongs into this category. There are many ways to categorise stocks by its size and one of the most used benchmarks is a company’s market capitalisation or also known as market cap. The market cap can be calculated by multiplying the company’s current share price by the total amount of shares on issue, also known as ‘shares outstanding’. The market cap is the total amount at which the market values the company.
Another factor to take into consideration is the stage of the business at which the company is at. Is the company in the growth or production stage of the business or maybe even still in exploration (for miners)? Is it reliant on external capital? Does the company generate positive cash flow yet?
Taking into account all these factors coupled with the implied market cap, helps you determine if the company is a small or mid-cap stock. There is no common definition and different markets have different benchmarks depending on the individual characteristics of the economy, the country or the size of the market just to name a few.
As per Wise-owl’s definition small caps in Australia have a market cap of typically less than $400 million. However the S&P/ASX Small Ordinaries Index, which represents the smaller members of the ASX, has companies included that range from around $10 million to several billion. The average size of the market cap is somewhere around the $400 million mark.
Australian mid-cap stocks with advanced business operations are often being referred to as the stocks on the S&P/ASX 200, not including the leading 50 companies on the S&P/ASX 50. The average market cap of mid-caps is somewhere between $500 million and $3bn whilst some may be valued as high as $7bn.
Fine line between Small and Mid-Caps
At the lower end of the chain there is sometimes a fine line between small and mid-cap stocks and some of the criteria may overlap. In some instances, a company with a smaller market capitalisation may fall into the higher category as its business operations are more advanced than those of a company with a bigger market cap. Due to the similarities small and mid-cap stocks are often being put in the same group and commonly referred to as ‘Growth Stocks’.
What is the Difference to Large Cap Stocks?
In Australia large capitalisation, large-cap or sometimes ‘blue-chip’ stocks are the largest companies listed on the Australian Securities Exchange (ASX). Most research firms classify the largest 50 companies by market cap as large cap stocks, which can be found in the S&P/ASX 50 index. Those companies have a median market cap of between $5bn and $50bn. The largest company on the ASX by market cap is currently Commonwealth Bank of Australia (ASX:CBA) with a market cap of more than $100bn as of September 2015.
Common characteristics of large cap stocks in Australia are:
Long-lasting and established business operations
Consistent and reliable dividend payments to its shareholders
Media coverage and interest of the general public
Often considered as ‘safe’ or ‘less risky’
Why Invest in Small and Mid-Cap Companies?
Investing in small and mid-cap stocks may have several advantages or disadvantages for your portfolio. Depending on your personal situation and your willingness to take risk, you want to consider to diversify away from large-caps and to allocate a certain portion of your portfolio to small and mid-caps. There is no rule and definite answer as to which ratio is correct. A conservative investor could potentially have 80-90% in large caps and 10-20% in small and mid-caps, while a more aggressive investors could increase his/her interest in small mid-caps to 40-60% or even more. If you want to determine the right strategy for your portfolio, we recommend you talk to a financial planner or feel free to give Wise-owl a call on 1300 306 308.
Here are some of the common advantages and disadvantages/risks:
Often greater potential for capital growth
Less affected by macroeconomic turmoil
Management’s actions have great impact
- Often higher risk profile
- Often reliant on external capital
- Low liquidity may complicate transactions
- Many small-caps don’t pay dividends
A Guide to Investing in Small and Mid-Caps
As soon as you are aware of the risks and rewards associated with investing in small and mid-caps, we recommend that you determine a basic strategy and stick to it. Keep in mind that every investor has different goals and expectations and individual circumstances which may affect the strategy. The following questions may help you determine an appropriate strategy:
How much am I willing to invest in small and mid-caps?
What’s the relative weight on my overall portfolios? (e.g. 10%. 20% or 40%)
How many individual positions do I want?
How much am I willing to risk per position?
Should I engage with a finance professional?
As soon as you have come up with a broad strategy that you feel comfortable with, the most difficult question will be which ‘growth’ companies to buy. Whilst the basic principles of research are similar compared to blue-chip companies, analysing small cap stocks can be a little tricky, especially if those companies are not making a profit yet. Valuations as well as earnings forecasts are often based on assumptions, company specific catalysts and personal views. However there are certain guidelines that can help you find great growth companies with favourable future outlooks.
Here are some tips:
Management: How strong is the track record of the management team?
Financials: Is revenue rising? What’s the development over the past three financial years?
Catalysts: Which factors are likely to drive the share price?
Hurdles: What are the primary risks?
Industry: What is the general outlook for the industry?
Stock price: Is the stock price rising?
Investment view: Is the balance of risk even, favourable or negative?
Wise-owl is the Small-Cap Expert in Australia
Wise-owl was the first company in Australia to specifically cover small-cap companies on the ASX. Until today the ‘Growth Portfolio’ remains one of the most attractive features of our service and no other company in Australia has such an in-depth understanding of the risks and rewards associated with Small-cap investing. Our head analysts Tim Morris has been featured on Bloomberg, Reuters, Sky Business or the Australian to share his expertise about the small and mid-cap industry of Australia.
Every research report in our ‘Growth Portfolio’ follows the same strategic model and we only recommend companies that satisfy all of our criteria. The outlook for these recommendations is generally long-term which has yielded in above-average returns over the past 15 years.
If you want further information about small and mid-cap stocks and you are a subscriber, log on to the portal or get in touch with your advisor. If you are a guest feel free to sign up for a free trial or call 1300 306 308 and talk to us today.