Investing in small companies: making a big difference?

At a glance

• Smaller companies can be more volatile than large companies but may have higher potential for growth.
• After years of underperformance, there are attractive valuations within the asset class.
• Smaller companies are often used as a layer of diversification by investors.

When investing in equity markets, size can have a big impact on volatility and risk.

The smaller end of the market can be buffeted by overall movements more than bigger, long-established companies. It’s much like the real world – smaller items can get blown around more in a storm.

The appeal of small caps is their potential for strong earnings growth. As they tend to be early-stage companies, in theory they will have more room to grow. Many consider them to be the innovators of tomorrow.

For example, Amazon today is one of the largest companies in the world. But it has only been around since the 1990s. At one point in its ascension, it was a small cap. Of course, not every small cap becomes a giant. Some stay small but still offer good growth.

It’s important to note that there is a cost for this higher potential. While smaller companies have, in theory, more room to grow, they also offer heightened volatility.

Active management

Smaller companies can be attractive for active management.

Typically, small companies will receive less analyst coverage compared to larger companies. As a result, company values are likely to suffer from mispricing, which can offer a potential opportunity to long-term investors.

For example, scores of investment houses will have analysts reviewing every announcement or nugget of information for companies like McDonalds or Meta, looking to try and find any insight that might give a slight competitive edge over rivals. In contrast, smaller companies will be receiving much less attention. This could see the wider market not fully appreciating a smaller company’s future potential, leaving its share price temporarily below where it should be.

This gives active managers greater opportunity to find these undervalued, overlooked businesses. Skilled stock pickers can uncover and exploit these temporary mispricings. While mispricings do exist in the large-cap market, they tend to be more limited. The lack of publicly available data and the need for on-the-ground research means active fund managers can retain a significant edge.

Past performance

It is no secret that small caps have generally underperformed in recent years. Despite recent reversals, equity markets have generally been driven by the rise of massive technology companies.

However, as the saying goes, nothing last forever. Years of lopsided performance mean that many large caps look expensive, while small caps, as an asset class, seem relatively cheap.

Looking ahead, Ilya Davar, SJP’s deputy head of equities, believes that the small-cap market is poised for rediscovery: “We think the odds of positive future returns are pretty good. Recent past performance has been weak, valuations are depressed and sentiment is quite negative, especially when compared to larger companies.”

“We’re seeing valuations at levels that have, in the past, offered exceptional entry points. History suggests this has been a precursor to strong future returns,” he explains.

Diversification

Despite these strengths, the volatility of small caps mean they are generally used in conjunction with other more mainstream investments to add a layer of diversification.

Davar explains: “Small caps often behave differently to large caps, especially during different market environments. Adding exposure can smooth overall portfolio volatility and enhance returns across a wider range of market conditions.”

Past performance is not indicative of future performance.

The value of an investment with St. James’s Place will be directly linked to the performance of the funds selected and may fall as well as rise. You may get back less than the amount invested.

SJP Approved 20/03/2025