What’s the best way to pick good small-cap stocks for my investment portfolio?

September 29, 2023
Written by Aman Budhwar
What’s the best way to pick good small-cap stocks for my investment portfolio?

As seen in Financial Post: FP Answers on September 29, 2023

Q: After a couple of lucky small cap stock picks, I’m becoming more interested in adding small cap stocks to my portfolio. Small cap stocks don’t have a lot of analyst coverage so how do I know what I’m getting? What role should small caps play in my investment portfolio, what is the typical holding period for these stocks, and when do I know it’s time to sell? Finally, is now (a period of higher inflation) a good time to buy them? — Ava D. 

FP Answers: Small caps are often the unsung heroes of portfolio returns because they often punch above their weight, or, in this case, their market capitalization. It has not escaped investors’ attention that, as of June, only 7 U.S. large-cap tech stocks have accounted for the bulk of returns in the S&P 500. This type of narrow dominance, where a handful of popular stocks attract an outsized amount of capital, means that the remainder of publicly traded companies are overlooked—and no sub-sector has been more overlooked than small cap stocks. In fact, they are probably the most unpopular they’ve been in a very long time.  

 As a point of comparison, the forward price/earnings ratio of the S&P 500 is 18.5 vs the S&P 600 (of small cap stocks) is 13.2 This massive difference is all the more remarkable for the fact that, historically, small cap stocks have enjoyed a premium valuation over large caps. Could they become even more unpopular in the near term? It’s possible. But, if history is any guide, as markets revert to their mean averages, quality publicly traded small cap companies are like a coiled spring and may deliver impressive future returns.  

 You’re right that small caps receive nowhere near the amount of coverage of large caps. This is not necessarily a bad thing. The relative lack of analyst coverage and price projections means that sometimes there can be a wide disparity between what a company is worth and its current price. Savvy investors can potentially benefit from this price differential once the valuation gap is closed. It’s important to distinguish between small cap and nano or micro-cap stocks. As per the S&P Dow Jones indices classification, small cap stocks in Canada range in market cap from $25 mln to $2.5 bln and in the U.S. the upper range is higher at US$4.6 bln. In, EAFE and emerging markets the ranges are up to US$8.5 bln and US$10.5 bln, respectively.  

 Contrary to popular opinion, small caps are not always young and unproven companies. Many small cap companies are well established businesses with good balance sheets, a history of steady growth, and of returning cash to shareholders by way of dividends/share buybacks. Their relative lack of coverage does however make it is more difficult for the average investor to find quality small cap companies compared to their large cap brethren. There are a number of active fund managers who specialize in small caps, both domestic and international. Even for D.I.Y investors, in this area, it may be prudent to outsource this sleeve of one’s portfolio to the specialists.  

As to what role small caps can play in your portfolio, there are several proven benefits of having an allocation to them: 

  • Small caps bring diversification. A well-diversified portfolio decreases risk and volatility and can create an optimal risk/return balance. 
  • Historically, small caps outperform large caps over the long term so they can enhance total returns.  
  • Often small caps are domestically focused businesses. During periods of rising inflation, they are better able to raise prices to maintain their profit margins. 
  • The current geopolitical backdrop of international conflict and the trend toward onshoring can benefit domestic businesses as they will face less global competition.  
  • Small caps may become acquisition targets of larger companies, thus providing a profitable exit for shareholders.  

To your question about how long one should hold a small cap stock, the only honest answer is, “it depends”. Some reasons to sell a position could include if the business changes in a material way that diminishes its prospects, or when the investor finds a more attractive opportunity for their capital. By their nature, small cap stocks are less liquid than larger companies that trade millions of shares per day. Their relative lack of liquidity can make an exit more difficult. Investors need to exercise patience and pay close attention to the bid/ask spreads. For this reason, limit orders are advised when trading in small caps.  

For the average investor seeking to grow wealth over the long term, an allocation of 5-10% to a small cap strategy is appropriate. There are periods, such as the one we are currently in, when a tilt toward small caps looks particularly attractive.  

Aman Budhwar, CFA, is a portfolio manager at PenderFund Capital Management Ltd.


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