How small businesses offer great investment opportunities for the future
Stocks of small cap companies are inherently riskier than large stocks.
Smaller stocks, with smaller market capitalization, make up the vast majority of publicly traded companies, whose total market value typically ranges between $250 million and $10 billion each. The huge size of this universe means there is less analyst coverage and information about the stock can be scarce, making it a less efficient market.
But that does not mean that it is not an excellent asset class in which brilliant businesses can be found that offer a differentiated profitability opportunity. Rather the complete opposite. “At times when there is a cycle of greater economic expansion, it is the smallest businesses that are the most generating returns ,” comments JP Morgan in a recent report.
Stocks of small cap companies are inherently riskier than large stocks. Its smaller size means that liquidity is limited. They are often more sensitive to the economy and may need to take on debt to finance their growth. They can also be perceived as immature businesses, which have not gone through the test of various economic cycles. All of this means that they are more susceptible to experiencing price volatility.
“As a higher beta asset class, small cap stocks tend to fall the most during periods of uncertainty, although they rebound strongly after contractions and often outpace the recovery of large stocks,” says Columbia Threadneedle in a dedicated report. on smaller companies.
An example is the pandemic in 2020. When lockdowns were imposed, small companies were more affected than large ones , and recorded drops of around 40% at the peak of the losses, compared to 33% for companies. large cap.
However, as restrictions eased and business and consumer spending increased again, there was renewed interest in this asset class and its rebound was more pronounced. Both asset classes closed 2020 with a return of around 16.5%. This is something that must be taken into account for the future.
Look beyond our borders
There is an assumption that small companies tend to focus on their home market. Any fluctuation in the regional economic or political outlook will affect small stocks more. “Although a company’s address does not dictate the quality of its business, nor does it indicate where it generates its income, its price can be influenced by regional market sentiment,” they comment from Columbia Threadneedle.
Investing globally reduces exposure to a single or small group of equity markets , allowing investors to capture potential excess returns from a broader set of small-cap opportunities, many of which are companies. international.
“Indeed, over the past 25 years, the risk-adjusted returns of small global companies have been higher than those of individual regions,” they highlight.
Quality vs. value
A cheap valuation shouldn’t be the only reason to invest in something. Small companies often turn to short-term financing to support their growth, assuming they have access to credit.
Following last year’s US regional bank crisis, credit to small businesses has been contracting. And, of course, any deterioration in economic confidence will inevitably have an impact . For many companies, it is quite possible that this discount is justified.
“For this reason, we believe that now is the time to invest in quality small-cap securities,” the manager says. Quality companies typically have relatively low leverage and strong balance sheets, so they should not be as affected by the need to refinance debt at higher rates. “They tend to be cash-generating and should be better prepared to weather a contraction,” she adds.
This supported them in the early days of the pandemic and should mean they are more well positioned in the event of an economic slowdown. In addition, many have pricing power, which allows them to resist well in times of inflation.
Many smaller companies should also benefit from the same structural opportunities that exist for large caps. It could be the expansion of AI, innovation in healthcare or solutions to the climate crisis, both its causes and its impact. Small companies are often the enablers, providing the essential products or services integrated into their customers’ processes.
Some of the most attractive opportunities can be found in this quality group. When there was the 2022 revaluation, investors shifted from more expensive growth stocks to cheaper stocks, companies exposed to energy or those considered defensive. Little attention was paid to the fundamental quality of the companies. Those trading at a premium to the market – as is often the case with high-quality companies – were hardest hit during the revaluation.
“At first glance, some of these companies may not appear ‘cheap’ compared to the broader market, for example on the basis of a simple price/earnings ratio. However, the constant and cumulative nature of their profits means that they remain cheap relative to their intrinsic value. They are companies with a proven track record with good cash flows, and they should be able to resist in a high interest rate environment,” they argue from Columbia Threadneedle.
“The investment opportunity in many of those quality companies that suffered a sell-off is still valid. They now offer an attractive entry point for active investors at cheaper prices than previously,” they conclude.
