Before becoming the global mega companies they are today, names such as Netflix, Amazon and Microsoft started life much smaller. As they became more successful, their assets boomed and today are among the largest companies in the world.
Given this success, investors are often looking for the next big name, essentially looking for tomorrow’s winners, today. One route to this growth is small cap investing. Traditionally seen as those companies at the start of their growth journey, the term small cap simply means small market capitalisation and it is an area that has traditionally been a rich hunting ground for investors.
Outside of the FTSE 100, the UK is home to some great small cap stocks. These can be found in the FTSE 350 Index and the dedicated FTSE UK Small Cap Index.
Unlike their larger peers, whose earnings mainly come from overseas, UK small caps – and small caps in general – are seen as more of a domestic play of investing. The definition of small cap varies and can shift over time, but generally the companies deemed to be small cap will be in the bottom 10% of the UK market in terms of their market capitalisation.
Here are three examples of some names you might know and others you might not, all of which are listed on the London Stock Exchange (LSE).
Proving that not all small caps are not household names, is the furniture retailer DFS. Enforced lockdowns and the effect of spending more time at home, has led Brits to spend more money on home improvements, and retailers like DFS have reaped the rewards. At the start of January 2022, the company reported a ‘strong order intake performance’ across its first half, adding that the post-Christmas sales period had got off to a strong start. Gross sales were up 10% on the 2019 pre-pandemic comparator for the 26 weeks ending 26 December.
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According to FE Analytics, in 2021 the FTSE UK Small Cap Index rose 19.1% (just beating the FTSE 100 which was up 18.4%). However showing just how much capacity there is for index beating stocks further down the market cap scale, the car retailer Pendragon saw its share price jump 77.1%. Pendragon is the second largest motor retailer in the UK. It operates the Evans Halshaw, Stratstone, brands of Quickco, Car Store used car supermarkets in UK, and dealerships in the US.
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Another household name sitting in the UK small cap space is Halfords. The UK’s largest retailer of motoring and cycling products and services has seen recent trading impacted by the Omicron variant, as shoppers have stayed away from stores. Laura Hoy, an equity analyst at Hargreaves Lansdown notes that as the cycling boom seen this time last year looks to be tailing off, it places the spotlight firmly back on Halfords’ motoring services. “That’s where we think the group has fundamental strengths,” she says. “The balance sheet is also in good health. That financial strength means the ordinary dividend is back on the table, but any extra surplus cash will first be funneled to reinforcing finances and investing for growth.”
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There are small cap companies all over the world, so you don’t have to stick with stocks closer to home if you don’t want to. Investing in some global stocks means that you can diversify your portfolio, but you can also encounter foreign exchange fees and fluctuations.
Cybercrime has boomed during the pandemic and lockdowns and the task of protection has become more and more complex as data are stored both on premises and on the Cloud. Co-founded in 2004 and going public in 2014, Varonis is a New-York based software company which has developed a security software platform that allows organisations to track, visualise, analyse and protect unstructured data. The stock is listed on the Nasdaq and Russell 2000 indices.
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Meal kit boxes have grown in popularity during the Covid pandemic, and one company catering to this demand is German-based HelloFresh. Listed on the Frankfurt Stock Exchange since its Initial Public Offering (IPO) in November 2017, it is now the largest meal-kit provider in the US and also has operations in Australia, Canada, Denmark, New Zealand, Sweden, and Western Europe. In January 2021, the company announced the launch of a share buyback programme of up to €250m, representing approximately 2.5% of its outstanding capital at current market valuation.
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South Korea’s Ecopro BM, a developer and manufacturer of advanced materials such as high-nickel cathode materials used in electric vehicles, recently become the largest stock in South Korea’s junior stock market, the Kosdaq. The company’s share have been buoyed by high expectations for the healthy growth of the battery market backed by the burgeoning demand for electric vehicles. Its shares soared 157.67% since the end of 2020.
The major attraction of investing in small caps is their growth potential. Smaller quoted companies have long had the capacity to outperform their larger counterparts – because of their size, small caps have the potential to grow more quickly.
In addition to their prospects for growth, small caps also have the advantage of being acquired by their larger peers, and they are generally seen as a beta play on market performance owing to their closeness to the “real economy” and domestic consumer trends.
“Unfortunately for small cap equities, many of the tailwinds of the last decade were not predicated on a strong real economy, but rather a considerable amount of central bank support in a low inflation, low growth environment,” says Chris Rush, investment manager at Iboss. “This environment resulted in large cap growth names outperforming despite the economy rather than because of it.”
Fortunately for global small caps, Rush says this could be about to change. He notes that record-breaking inflationary figures and the potential for increased demand for real assets could indicate an uptick in real economic activity and demand. This is a factor that should benefit companies more sensitive to positive economic conditions.
“We feel that smaller cap equities present an opportunity to diversify portfolios away from the central bank monetary play (and companies that have benefitted from that) and toward the real economy,” he says. “This is a factor we feel should not be overlooked when constructing any portfolio.”
All investing should be regarded as longer term. The value of your investments can go up and down, and you may get back less than you invest. Past performance is no guarantee of future results. If you’re not sure which investments are right for you, please seek out a financial adviser. Capital at risk.
Investing in smaller companies does carry more risk than investing in more established large caps, or blue chips companies as they are also known. This is because for every Netflix and Amazon access success story, there are those less successful tales.
Small-cap companies also tend to have much smaller customer bases, meaning their prospects are more uncertain and often tied to a specific geographical area. As a result, many are unable to survive through the rough parts of the business cycle.
Stock market volatility is also a much larger factor to consider when investing in small caps. It is common for the price of a stock to fluctuate 5% or more in a single trading day, which is something many investors might not be able to stomach. Since these stocks often have less liquidity, it is also more difficult to exit a position at the market price.
The primary advantage of investing in small cap stocks is the significant upside growth potential that is unmatched by larger companies.
However, the golden rules of successful investing should still be applied to small caps. Diversification is a must. This is because these opportunities to profit also come with some risks. Small cap investors sacrifice stability for potential. If you can take on additional levels of risk, exploring the small cap universe might be for you. If you are more risk averse however, these might not be the most suitable investments for you. The golden rules of successful investing should still be applied to small caps. Diversification is a must.
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