The 200 smallest stocks in the S&P/ASX 300 index have underperformed the 100 largest stocks by 46 per cent over the past three years.
It's why Intelligent Investor is now casting its stock-catcher's net a little wider.
Rotating a small proportion of your investment capital out of expensive big companies into smaller and cheaper ones makes sense.
But what's the secret to success in small stocks? The risk inherent in small stocks occasionally encourages investors to take leave of their senses. Proud of their prudence when it comes to the banks, Woolworths and BHP Billiton, they mimic deranged bungee-jumpers when contemplating small companies.
The fact is that there's no place for play money in the stock market. An investment is either sensible or it isn't, but there are still some dos and don'ts to consider before diving into smaller caps.
Small company DOs
1. DO look for a market niche. The best small companies do one thing well, often focusing on a particular geography or market niche. Trade Me dominates New Zealand, a market too small for eBay to be bothered with. OzForex offers smaller customers a way to transfer money internationally that's easier and cheaper than the big banks.
2. DO look for revenues and (preferably) earnings. Exploration and early-stage medical companies - with no product to sell - are unworthy of your capital. Without revenues you can't value a business. Nanosonics recently made our buy list because it has regulatory approval and revenues that are growing fast. It also has that niche thing.
3. DO analyse the competition carefully. Small companies rarely operate in cartel-like industries like grocery retailing or the banking sector. Even small companies that dominate their industry can become complacent - cloud-based accounting software provider Xero, for example, has put (the now private equity-owned) MYOB on the backfoot in barely two years. Hotel booking website Wotif's margins will be crunched by the emergence of international competitors. Consider all possible threats.
4. DO worry about debt levels. Sure, Intelligent Investor funds did well buying heavily indebted property stocks such as RNY Property Trust and Ingenia Communities Group at big discounts to net tangible assets. Exaggerated debt concerns were in fact a source of the value on offer but, generally speaking, small companies and debt are like oil and water. They don't mix.
5. DO look for management ownership. One of the best things about small companies is that director ownership of stock is more common. When management owns a decent chunk of the stock they're less likely to do something stupid. ARB Corporation's management have become very rich by being shareholder friendly.
6. DO consider stock liquidity. If an investment hasn't worked out, or you just need cash, it can take weeks to sell your shares in small caps. In tough times buyers can completely disappear. Check stock turnover before you trade.
Small company DON'Ts
1. DON'T buy too much. Smaller companies are higher risk. While you can justify up to 6 per cent in a second-line stock such as Trade Me, more speculative plays such as SomnoMed and Nanosonics require lower portfolio weightings of about 2 per cent. It's wise to buy an initial position at half the suggested maximum, giving room to move if the stock becomes cheaper.
2. DON'T chase the share price up. Not only is it more difficult to sell a small stock, it's more difficult to buy. Poorer liquidity means the price can move up quickly but will often fall back. Stick to your purchase limits.
3. DON'T expect miracles. Small stocks can produce higher returns than large stocks but they aren't lottery tickets. Only a tiny proportion will ''ten-bag'' - or rise tenfold - and even that might take a decade.
Some small companies will become very successful, most will be mediocre, and a few will go bankrupt. Expect to buy your share of duds.
When it comes to selecting small stocks, one size won't fit all. Make sure high-risk stocks clear high hurdles before they earn a place in your portfolio.
With small stocks being better value than they've been in years, it's time to dip a toe in the risky river. Just remember to follow these rules to avoid being swept downstream.
This article contains general investment advice only (under AFSL 282288).
Nathan Bell is Research Director of Intelligent Investor Share Advisor. For a 15-day free membership visit shares.intelligentinvestor.com.au/smh-free-trial.
