Dangers of small cap stocks

Very few make the grade

INVESTING SCENTS:BY S.DALI

MANY investors would be indifferent to investing in large cap stocks and small cap stocks. The inherent dangers of investing in small caps need to be investigated so that investors have a better grasp of the risks involved.

There is a very popular local fund manager who has performed admirably, largely thanks to his picks in mid and large caps. However, his track record was compromised somewhat by his picks among small caps; in fact, it was pretty dismal.

The biggest attraction of small caps is the huge growth potential. Most successful large cap companies started at one time as small businesses. Small caps give the individual investor a chance to get in on the cheap. Everyone talks about finding the next Genting, YTL or IOI Corp. However, the reality is that very few small caps make the grade.

It is certainly easier to grow from a market cap of RM100mil to RM500mil but it's a totally different scale to grow from RM1bil to RM5bil. At some point you just can't keep growing at such a fast rate due to restrictions in the sector size.

While there are some funds that do invest in small caps, by and large the majority of funds are averse to them. That's because the fund would have to be small in size to invest in small caps. If you are managing a US$500mil fund, it's difficult to have sizable positions in small caps. No fund manager wants to look at 100 companies in their portfolio – the monitoring costs are too overwhelming. For mid size to large funds, to invest successfully in small caps would require hitting a lot of home runs every year – a debilitating task.

The coverage on small caps would also be scant at best. Lack of coverage means lack of exposure. Lack of exposure means the stock will not appear on their radar screen. What this means to the individual investor is that, because the small-cap universe is so under-reported or even undiscovered, there is a high probability that small-cap stocks are improperly priced, or usually under-priced.

The biggest drawback to investing in small caps is in the management. Typically, they comprise entrepreneurs who built the company from scratch to its listing capacity. We have to differentiate between people who had a great idea and those who have the ability to grow a company.

Statistics reveal that these entrepreneurs hold onto the company for far too long and do not have the expertise to take the business to the next level. It takes more professionalism and market savvy to turn a RM100mil company into a RM500mil company. Too many entrepreneurs are unwilling to appoint more professional managers, or are blinkered of the need to do so.

There are varying notions of what constitutes a small cap company. In the US, it is generally regarded as companies with market cap of less than US$500mil (which would be regarded as a mid cap in Malaysia and most of the smaller South East Asian countries).

Truth is, there are no hard and fast rules. I would categorise small caps in Malaysia as those with a market value of below RM500mil (because there are just so many of them) and then have another category for those under RM300mil as micro-caps. If we were to push the threshold higher, it would envelope the majority of stocks on the Bursa.

To better spot the better small caps is to examine the company's strategy and execution ability. First, the business needs to be scalable. Secondly, the company must know its market, competitors and its competitive edge. It also must have a clear plan to grow organically or via acquisitions. In addition, there must be increasing professionalism in the way business is run – be it at management or board level. There must exist a clear understanding of cost and capital requirements. Last but not least, is the execution ability. There should be goalposts or milestones marked and reached.

Small caps are able to ride a wave better because they are more agile given their size. The crunch comes when there is a recession or dramatic slowdown in their sector. Many small caps will perform well in a bullish environment but wither easily when the wind blows harder.

A lot of small companies arise from carving a niche in technology. However these companies also suffer swiftly from technology improvements and trend changes. Most do not have sufficient resources to commit at such an early stage into research & development in order to stay ahead of the development and technology curves.

Small caps usually do not pay much dividend as most of its profits will be reinvested to fund growth. This is an additional risk as no or little yield will mean investors would be buying for pure capital appreciation.

My final thought on the issue is that through my observation, I have noticed a certain danger of complacency among owners of small caps. Many entrepreneurs are satisfied once they get their companies listed on the stock exchange. In Malaysia, many of these owners stand to make RM10mil-RM50mil following a listing. Indeed, an attractive sum that can tempt many to “retire” and lose their drive to elevate the company.

p/s photo: Lin Chiling