Canadian Small Caps: High potential returns but with unique risks
As published in the Finance et Investissement/Conseiller.ca December 16, 2024 (In French) | Image by starline on Freepik
Winds of change are in the air. Years of rising interest rates to tame the inflation beast are slowly reversing as central banks loosen monetary policy. Recession fears are receding as the “hard landing” narrative has given way to the “soft or no landing” scenario. The headwinds that once drove investors away from small cap stocks are turning into tailwinds making this asset class highly desirable once again as mega and large cap stock prices climb a wall of worry. (“How much higher can they possibly go before a course correction?”) According to Morningstar Direct, small-cap ETFs took in almost triple the amount invested in 2023. Wall Street analysts’ earnings estimate on stocks in the S&P SmallCap 600 is expected to rise 22.1% versus 14.8% for those in the S&P 500 next year. This bodes well for investing in small cap companies. However, while small caps offer the potential for outsize returns, as has been the case historically, they also come with unique risks and challenges for investors.
Small caps have less liquidity than large-cap companies. This has two knock-on effects: increased volatility and potentially more expensive to trade for retail investors. Because they are less widely owned than larger companies, trading volumes are often small on a daily basis, sometimes as few as a couple of hundred shares compared to the multiple millions of shares traded in larger cap stocks. This can make it challenging to build a meaningful ownership position without affecting the market price. Secondly, the bid/ask spreads in small caps can be wide necessitating a different kind of buying/selling strategy than simply putting in a market order.
Smaller companies are less widely followed by analysts and less bought by institutional investors. This is both a benefit and a detriment of investing in this sector. Because the easily available research is scarce, investors who take the time to fully understand individual businesses can gain a valuable edge due to the relative inefficiency of this market segment. For example, a general basket of small or micro-cap stocks in a mutual fund or ETF will contain companies of varying quality—including some profitable or nearly profitable to struggling enterprises with poor prospects. The small cap space disproportionally rewards investors willing to do the due diligence and separate the wheat from the chaff.
Falling interests have been kind to all businesses but no more so than smaller companies that tend to rely more on external financing, such as debt, and are therefore more immediately affected by changing rates. This gives small caps a spicy flavour making them more reactive to the upside or the downside depending on the macro backdrop. Further, while large companies usually have a global reach, smaller companies are more domestically or North America- focused. Where the domestic economy goes, so go the fortunes of smaller companies because they are less able to offset slower growth in one region with higher growth and profits in another.
Because of these unique attributes, successful investing in small caps is often a “team sport” and achieved through owning funds managed by a team of seasoned professionals with proven track records throughout various economic cycles.
