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Why You Must Buy Small Caps

Posted by: Brian Dennehy
Why do smaller companies outperform?  And why do investors often avoid small caps? We consider both these questions and provide some answers, so you don’t miss out on the extraordinary potential.
 
Why do small caps tend to outperform? It’s reasonably clear, and here are just two reasons:
  • They are much more agile. It is relatively easy for a smaller business to double profits or margins or turnover.  It can do this through new products, new markets, bigger marketing emphasis, new processes which also enable cost cutting etc.  A super tanker of a large business cannot do this
  • They are under-researched. There is a lack of research by the dominant investment banks, largely because the sums they would wish to invest are too big. So little gems are often over-looked.
 
Can you afford to overlook 37% extra growth every year?
 
Between January 1994 and December 2016 the UK All Companies sector average returned 7.16% every year compared with the UK Smaller Companies sector average of 9.87%.  That's 37.8% more growth every year. 
 
And that's just the sector average.  If you have a means to select outstanding funds the results are even more impressive.  How about more than doubling the growth from the mainstream UK stock market represented by the UK All Companies sector?
 
Instead of 7.16% you could have enjoyed 16.27%. More than twice as much growth.
 
It was easy.  You would have used our Dynamic Fund Ratings.  More on that in our Dynamic Smaller Companies
Portfolio – to be published in the next few days.
 
A widespread phenomenon
 
Evidence for this tendency is not just widespread in the UK - it also applies to small caps globally. 
 
There is a theory called the Efficient Market Hypothesis that broadly states markets are efficient and you cannot outperform the market.  However, there is a volume of academic evidence making it very clear that investing into smaller companies is one (of the handful) of ways in which investors can consistently outperform the indices.
 
With so much evidence showing the considerable extra growth investors can achieve why are retail investors so reticent to invest in smaller company funds, where a full time expert (the manager) is effectively holding your hand?
 
This is a big topic (and we don’t have a lot of space!) but one view is that it is “behavioural”: even more experienced investors, who are aware of this potential, become a bit timid when confronted with the unfamiliar and under-supported.  Instinctively they would rather invest into what is familiar and relatively well supported – they follow the herd into big funds (or big names!) investing into familiar companies.  
 
Plus the word “smaller” is simply counter-intuitive – “I want to grow big but you want me to buy small?”
 
Solution: have a plan
 
The way around this is for investors to better understand these tendencies and also to establish a well thought out investment plan: write down why you buy certain funds to the exclusion of others, and ensure you undertake a regular review.
 
If investors can get over the behavioural tendency to avoid smaller company funds then what should they look for?
 
We will show you in the next few days, with the review of our Dynamic Smaller Companies Portfolio, and the funds you should be holding. (Gold members only)
 
ACTION FOR INVESTORS
  • Don’t discount smallcaps just because of the name
  • Make sure you have an investing plan…
  • …and don’t forget to check your funds at each review point!
Topic: Market commentary


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