Explore Small Cap Opportunities on the ASX

Navigating the Potential: Investing in Small Cap Companies on the ASX

First, what are small cap stocks?

They are all those companies that sit outside of the largest 100 on the ASX by market capitalisation.

The S&P/ASX Small Ordinaries index represents the smaller constituents of the S&P/ASX300 index. It is this index that is used as a benchmark for Australian small cap stocks.

Companies in this index generally have a market cap of $100 million to $2 billion.

The small cap space has more stocks to choose from but significantly less analyst coverage and lower institutional ownership.

This may sound unpromising for some, but it is precisely this that makes small caps exciting opportunities.

Why?

Market inefficiencies caused by low analyst and media coverage create mispricing opportunities.

Small cap stocks are largely misunderstood and underappreciated, thus presenting great total return opportunity for discerning long-term investors.

As there is less media, broker coverage and competing investor attention in the sector, there is a greater reward for investors’ own research, skill and effort.

Are the best ASX stocks small cap stocks?

If one looks at ASX stocks worth less than $500 million, they’ll frequently find some of the most exciting stocks in the world.

These small-cap stocks hold lots of potential because they have plenty of runway left. Some small caps can see price rises in excess of 100%, 200%, 500%, and sometimes even more than 1,000%.

What are examples of small cap stocks?

Take BrainChip Holdings Ltd [ASX:BRN] – an Edge AI applications developer. Brainchip was trading for 8 cents in June 2020 before jumping to 76 cents in September 2020, a gain of 800%.

It is also an example of what is called a multibagger stock – a stock that gains over 100%.

Or take another multibagger – Novonix Ltd [ASX:NVX], a battery materials and technology company. It has gained over 750% since trading for 25 cents in May 2020.

Such gains are possible because small-cap stocks can make one big deal, sign one crucial agreement, surprise the market with one big announcement, and see the value of their company skyrocket virtually overnight.

That could turn a stock worth a few cents into one worth a few dollars in a short space of time. And it could supercharge an investment portfolio in a way that almost no large company can.

Risk vs Reward: The Dynamics of Investing in Small Cap Stocks

Yes, small-cap stocks can be risky.

Small caps can have big price swings daily. Thus, it is frequently suggested to never put all one’s money in this part of the stock market.

This volatility means higher highs but lower lows. Small caps are also particularly sensitive to investor sentiment and investment flows.

Despite this, investment in small-cap stocks could pay off massively. That’s the risk/reward payoff here.

But one should always remember that the same volatility that can deliver huge returns in small-caps can also deliver huge losses. That’s what makes these investments so risky, but also so lucrative.

In the Loop: Latest Updates from the Small Cap News Circuit

Small cap investing is as much about what to own as what to avoid.

After all, more than 60% of all small caps delivered a negative return over the 10 years to 2020, leaving less than 40% from which to make money.

Investing in small caps, therefore, can take a certain level of investing acumen, experience, and steel.

This is especially true when considering the sheer number of investment opportunities in this market sector.

Investing in this market also requires equanimity in the face of drastic price swings. And equanimity usually follows conviction.

What strengthens conviction? Intelligent research.

When purchasing a car, we consider its price, fuel consumption, safety, we conduct test drives. We do all this as part of our research before parting with our hard-earned cash.

It’s the same principle with buying shares, especially in the small cap space.

It all comes down to finding quality and avoiding hollow hype.

What are some ways to assess a small cap stock’s quality? One can consider the stock’s:

• Business model
• Industry
• Stage-of-lifecycle
• Management
• Growth strategies
• Industry cyclicality
• Geographic exposure.

The more one understands a company, the more comfortable one is with their investment decision. As Warren Buffett said, ‘Never invest in a business you cannot understand.’

Apart from conducting due diligence on a stock, one can also consider implementing stop losses and limiting one’s position size (for example, keeping a trade to 5% of one’s portfolio).

That said, rigour research – with the associated sifting, filtering, identifying, assessing, and modelling stocks – can be a full-time job.

That’s why investors frequently make use of research reports by professional analysts to save time.

On that note, there is a underreported resource out there for small cap investors – the ASX Equity Research Scheme.

The free, ASX-backed scheme provides subscribers ‘high quality, independent research for undercovered ASX-listed small cap companies.’

Under the scheme, the ASX subsidises equity research on eligible companies by partnering with several well-established research brokers working in the small-cap space.

Since inception, the scheme has covered companies like Altium (ASX: ALT), Afterpay (ASX: APT), Vocus Group (ASX: VOC) and Nearmap (ASX: NEA).

Research from the ASX Equity Research Scheme is published in a weekly email bulletin on Friday afternoons with an average of six research reports per week.