Rollercoaster of small caps may be a top ride

THE share market rollercoaster is taking all investors on a white-knuckle ride, but none more so than those exposed to the minnow end of the bourse.

Small cap stocks tend to suffer more than their grown-up cousins because they have weaker balance sheets and lower liquidity, which means that it only takes low volumes of selling to depress the share price.

Small caps are also likely to be speculative – such as resources explorers and biotechs – with only an outside chance of developing a mine or a product.

They also tend to be poorly researched by brokers and fund managers, although this can be a good thing as hidden gems can be overlooked.

When investors become risk averse, equity funding dries up and most of these players would struggle to get within a pinstriped banker’s brolly length of a loan (at least they’re not troubled by soaring interest rates).

In the year to date, the ASX small ordinaries index has retreated 16 per cent, while the top 200 stocks have fallen by 7 per cent.

Most small caps are growth stocks – code for little revenue or earnings but big prospects – and the growth sector generally has been shunned by now riskaverse investors.

So why bother with the tiddlers? For a start, the “small caps” are not necessarily small – many of them have market valuations in the billions. Socalled micro caps are valued below around $500m while nano caps are in a speculative league of their own, with market caps from $50m-ish to a couple of silver coins you would throw at a tuneless busker.

While small caps are sold off faster than the larger stocks, the corollary is they can do better in a recovery – sometimes much better.

BetaShares chief economist David Bassanese says playing the small caps is not so much a matter of picking the hidden gems, but avoiding the bad ones. The latter can be weeded out by excluding those with too much debt, are loss makers or are running out of cash.

Encouragingly, the small caps outperformed the broader market during the recovery periods of the pandemic and the global financial crisis – sometimes spectacularly so. Past rewards for emboldened investors include the buynow-pay-later hero Afterpay, which emerged from obscurity and was taken over this year by US fintech Square for $39bn (it remains ASX listed as Block Inc, under the code SQ2).

Fortescue Mining (FMG, market cap $58bn) and Domino’s Pizza Enterprises (DMP, $6bn) also evolved from the small-caps mire.

For those unwilling to pick individual winners, exchange traded funds or other collective vehicles can be a handy way to spread risk across multiple stocks.

The BetaShares Australian Small Companies Select Fund (SMLL) invests in 50 to 100 tailored small caps and its 6 per cent oneyear return to the end of April was double that of the small ordinaries accumulation index.

Fund manager Ausbil’s Australian small cap fund surfs energy transition stocks such as Core Lithium (CXO) and copper-gold hopeful 29 Metals (29M);

and inflation resistant stocks such as fruit and vegie grower Costa Group (CGC)

and health insurer NIB Holdings (NHF).

Building group Johns Lyng (JLG) – a fixer-upper of buildings after floods and other tempests – is an alternative exposure to the climate change theme.

In the year to March, the Ausbil fund had returned 29 per cent, compared with just under 10 per cent for the small caps index. But as they say in the super funds ads, past dazzling performance does not guarantee future glowing returns. And if pain persists, sack your broker. This story does not constitute financial product advice. You should consider obtaining independent advice before making any financial decisions