Investing In Small Capitalization Companies
The term 'small cap' refers to companies with relatively small market capitalization. Market capitalization is calculated by multiplying the number of outstanding shares of the company by the current price per share. The exact definition of small cap, however, varies among brokerages and fund houses. Equity investors have a common dream; investing in small-capitalization (small-cap) companies that eventually double or even triple their market capitalization as their share price grows by leaps and bounds. If one invests in such companies during their early days, a modest investment could balloon into a substantial sum. The beauty of small-cap companies is their size, which allows them to grow at a rate that is almost impossible for larger companies to replicate. Say, the construction firm's shares were around $0.70 at the start of the year. At the end of September, they were trading at slightly over $2. The growth of this particular small-cap company shows that there is substantial profit to be made by investors who acquire fundamentally sound companies at the right price. There are also opportunities to find small caps trading at a discount. Smaller companies don't always conduct investor's relations activities (to distribute information on its financial performance and activities to potential shareholders) and this makes it hard for analysts to get to know their business. Larger, well-known companies receive much more coverage, so their shares are likely to trade at a fair value. This means that astute investors can make profits once their 'hidden gems' are discovered by the market, especially if institutional investors invest in them. The volume of shares bought can push prices up by 20% to 30% in a single day. However, generally, investing in small-cap stocks face more risk. There are two major types of risk faced by small-cap companies, which are fundamental and market. Fundamental risk is the possibility that earnings might fail to meet expectations, perhaps due to inexperienced or poor management. Insufficient financial resources, problems with business processes or competitive companies vying for the same customers are other situations that contribute to a small cap's fundamental risk. Before investing, you need to decide if the company can overcome its hurdles and this can be difficult to do if analysts don't cover it. Moreover, the sheer number of companies in the small-cap universe makes it harder for investors to find hidden gems. The market risk faced by listed small-cap companies is lack of liquidity. There's a stigma attached to these shares because of the low trading volume. Big funds only dabble in these companies because it can be very hard to exit if you're holding a lot of its shares. However, because the turnover is low, these shares aren't as volatile as some may expect. In the search for 'hidden gems', investors can turn to brokerage firms that offer their research and investment advice on small-cap companies. As one can be overwhelmed by the sheer volume of small-cap companies, start with companies in industries that you're familiar with. In periods of uncertainty, most investors prefer to hold blue-chip shares as they offer capital protection. However, small-cap companies can still play a role in your portfolio, depending on your risk appetite. An investor who can tolerate the risks of small-cap investing and has about 20 years before retirement can invest up to 15% of his portfolio in such companies. The challenge is in finding good companies. Michael Russell Your Independent guide to Investing |
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