The Discipline of Investing in Small Caps
June 12, 2025
There could come a time in our investment journey when we may think we need something a bit more exciting than just a bunch of blue-chip shares. I am at that stage.
Don’t get me wrong. There is absolutely nothing wrong with large-cap stocks. They have an important role to play in any portfolio.
With a judicious selection of large caps, we can even leave them to do what they need to do over the long term. One of the worst things that we can ever do is to tinker with them too much. But continually reinvesting any dividends that we receive is a must. It is the cornerstone of compounding.
The beauty of large-cap stocks is that they should just plod along and grow at a sedate pace. Large companies are generally perceived to be less risky. They don’t normally do anything too outrageous. At least we hope they don’t. Additionally, their sheer size can confer some level of stability to a portfolio.
That doesn’t mean that things can’t ever go wrong. Some blue chips have managed to badly disappointed investors. But it is a rarity. Generally, blue chips have more reliable revenue streams. They might also have a broader customer base, which can help to make their performance more predictable.
The downside, however, is that their predictability can lead to pricier valuations. The price to earnings ratio, which is the price that we pay for every dollar of earnings, can be quite high. That is because investors are more inclined to pay a premium for reliability.
After all, when a swathe of analysts covers blue chip stocks, there are very few places for large caps to hide. Analysts’ forecasts might only differ by a few cents in either direction in terms of revenue, profit and dividends. So, it is not surprising that bargains are few and far between among the blue chips.
Small caps are a totally different story, though. They are less well covered by analysts, which means that it may be easier for us to find undervalued stocks. But it does mean a bit more legwork for the intrepid investor.
On the plus side are cleaner accounts. Smaller companies tend to have simple business models that have not been complicated by frequent acquisitions and disposals. Their accounts are not only easier to understand but they also make forecasting more straightforward, if we are prepared to do the homework.
There is something else about small caps. Since their operations tend to be more local and limited in scope, it means that they could, if they want to, have more room to expand. It can be difficult for a large cap to double its revenue. But a small cap could if it wanted to.
Interestingly, though, small caps prefer to stick to their chosen niche markets. These markets are probably too small for large companies to bother with. However, to be a successful niche player, the target market should still be of sufficient size to be profitable. It should also have growth potential and preferably lots of repeat purchases.
Investment guru Peter Lynch once said: “If you stay half-alert, you can pick the spectacular performers right from your place of business or out of the neighbourhood shopping mall, and long before Wall Street discovers them.”
Consequently, if we are interested in small caps we should keep our eyes peeled. We should keep our minds open for interesting brands. In the main, we tend to associate big brands with big companies. But that could be a mistake.
It is natural to assume that bigger outfits will have mega bucks to spend on advertising. But it might surprise us to find that small companies can have big brands, too. It might have been true in the past that companies had to spend big to keep their products in the forefront of consumers’ minds. But not any more – social media, influencers, and viral marketing have changed the advertising landscape, appreciably.
To invest successfully in small caps, it is important to stick to tried and tested rules. Just because we are dealing with small caps doesn’t mean that we should abandon our principles. If anything, we should be doing more.
We should be looking for companies with a good track record of growing revenues and profit. Those businesses should have little or no debt. They should be able to generate lots of free cash flow. They should also demonstrate a long history of paying dividends.
But that’s not all. Shares of small caps can be volatile because liquidity in their shares could be low. Consequently, we need to build a carefully curated portfolio that could help reduce the swings in share prices. Banking on just one or two small caps is akin to jumping on a pogo stick.
The portfolio should be designed to generate as much regular cash flow as possible. That should allow us to turn volatile share prices into a boon rather than a bane. I can’t wait to get started.
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An earlier version of this article appeared in The Business Times.
Disclosure: David Kuo does not own shares in any of the companies mentioned.
The post The Discipline of Investing in Small Caps appeared first on The Smart Investor.
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