In the US, the evidence is clear that small caps
outperform – one study showed that small caps
have averaged a return of 20% since
the great depression, compared with 11%
for large stocks.
School of Business shows that
the small cap effect is greatest
among microcaps – so the smaller
the company, the better. Such
companies tend to be ignored by
research analysts at the institutional
brokers and also by large fund
managers. They have additional
risks to them like liquidity risk – the
chance that you won’t be able to
sell them when you need to – and
governance risk because of the
lack of scrutiny by the investment
analyst community. It may be that
these additional risks are the reason
for the premium. Transaction
costs are also higher, because
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ISSUE 4 – JULY 2015
the spread between bid and offer
prices is always higher on small cap
stocks compared with large, highly
liquid stocks.
These considerations mean that
small cap investing is really best
left to individual investors who are
going to be making smaller bets
and can be patient in waiting to
get good entry and exit prices. The
research suggests that these are
good elements to an effective small
cap growth strategy:
A long time horizon (decades,
preferably). The US research shows
that portfolios held for five years
or less do better in large caps than
small caps. Over five years, small
caps tend to win.
Discipline and diversification
become even more important. You
need a large portfolio of different
stocks to spread the risks.
You need to do the research
yourself, including assessing how
trustworthy management are
to report the real picture of the
business to you. You need to follow
the news media and even attend
results presentations.
Other growth investing strategies
include backing initial public
offerings of stocks and large
cap strategies that depend on
estimating growth rates. These
are all more difficult for smaller
investors to pursue.
Despite all the hype around value
investing, a small cap strategy could
well be wise for retail investors. ■