Small-Cap Equities

Many investors steer away from small-cap stocks, wary of their reputation as riskier and more volatile than their larger-cap counterparts. While this can be the case, investors avoid this asset class are missing out. In our opinion, small-cap stocks offer fantastic opportunities for research-driven investors who are able to do the deep dive to find the hidden gems.

Small-cap stocks enjoy several advantages. With close to 3,000 listed U.S. stocks (excluding penny stocks), this category has plenty of companies to analyze. Small caps can offer greater and faster growth potential than their larger peers, as they are earlier in their growth trajectory and have captured just a small portion of their overall target market.

In addition, small caps tend to be underfollowed on Wall Street. On average, a large-cap company is followed by 27 analysts, compared with six for the average small cap. This sparser coverage in part is a reflection of SEC regulations that make it difficult for funds to own more than a certain percentage of a company. The result is that many large mutual funds forego small-cap companies because they cannot take a position big enough to have a material impact on their overall portfolio.

It takes extensive research to spot promising companies early on. Many small-cap stocks fly under the radar,. When compared to large caps, stock returns of smaller companies are more driven by company-specific events and less so by industry and market events.1 This means the skilled stock picker who is able to understand and evaluate a company’s idiosyncrasies has more opportunities in this asset class.

On the downside, small caps can be volatile. As long-term investors, you must be accustomed to riding out short-term volatility and must be willing to selectively take advantage of a downswing to initiate or build a position. As less well-established businesses, small caps can also carry more risk than their larger peers.

Thus, it’s essential as a long-term investor to take a multi-faceted approach to managing risk, which is critical to successful management of a small-cap portfolio.

Emphasizeing fast-growing areas of the economy such as:

  • Cloud computing
  • Cybersecurity
  • Semiconductors
  • Defense and aerospace
  • Genetics
  • Minimally invasive surgical procedures
  • Biotechnology and pharmaceuticals
  • The use of technology in health care products and services
  • Unique retail concepts

Long-term perspective, allows you to do the due diligence needed to gain an in-depth understanding of these companies, including getting to know their management teams and visiting key sites they may hold. It also gives us the chance to research new investment prospects.

You should look for what you believe to be companies with strong management, durable competitive advantages, and open-ended growth opportunities, at an attractive valuation.

Smaller companies can enjoy phenomenal growth in a short period of time. However, as any small-cap portfolio manager can attest, you can have volatility on the downside as well. Although you are long-term investors, the volatility of this asset class demands that you incorporate risk management into every aspect of your investment process.


References:

  1. https://www.baronfunds.com/sites/default/files/baron-investor-baron-discovery-fund-9.30.23.pdf
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