Five good reasons to look at small caps

Analysis

By James Ogilvy, Annabelle Vinatier and Jean-François Cardinet, European Micro, Small & Mid Cap Funds Managers at Lazard Frères Gestion

Small caps have a number of attractive assets for investors. However, stocks need to be picked carefully and an efficient diversification put in place.

Investing in the small caps segment requires good risk control. Although small cap stocks are not generally more volatile than large caps, individually, their share prices can suffer significant short term fluctuations. This is due to their lower liquidity and more specific business areas than large cap stocks. Diversification is therefore vital for investing in this market segment and for limiting eventual losses related to the volatility of certain stocks.

Investing in a fund specialised in the segment can be a good way of ensuring this diversification and thereby making the most of the specific interests offered by small and midcaps. Here are the five main ones:

  1. Small caps tend to develop more targeted businesses than large caps. As an investor, it is therefore possible to know exactly what you are investing in. For fundamental investors, this above all enables detailed analysis of products, the market and the competitive environment in which the companies are evolving. The bigger and more complicated a company is, the more difficult this becomes.
  2. Since they are at an early stage of their development, small caps tend to post higher earnings growth rates than large caps. Over time, this growth momentum results in a better performance. For example, the EMIX Smaller Europe Euroland index has generated an annualised yield of 12.25% since 31/12/2011, vs. 9.79% for the Eurostoxx. This performance remains fairly uncorrelated with large caps, thereby enabling a diversification of risk in investor allocations.
  3. Contrary to the very efficient large cap market, which is followed by many analysts, the small caps market tends to be less monitored by the market. As such, a share price may not precisely reflect the true underlying value of the company. This can lead to eventual under- or over-valuations, that investors can exploit with a view to a later return to normal.
  4. The small caps universe contains many companies managed and controlled by their founders or their founders’ families. These companies tend to be managed more cautiously, with a very long-term strategic vision that also helps limit risk.
  5. Management’s influence is also more direct and less diluted than at large groups, thereby enabling small and midcaps to be more reactive in terms of changes in economic conditions. This is naturally an opportunity but also a risk, since a bad strategic choice can have serious consequences. Hence the importance of clearly analysing management’s intentions before investing.

Note finally that contrary to preconceived ideas, small and midcap activity is not restricted to a national or local scope. These companies are sufficiently large to be listed on the stockmarket and are generally worth hundreds of millions of euros. They often sell their production in several countries around the world and implement ambitious sales strategies in order to do so.

In all, investing in the small caps segment helps provide momentum within a more global asset allocation on the equities markets. In return, the investment is naturally more risky and requires significant work to monitor the companies as well as active management to build an optimal portfolio.

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Risks related to small caps: Risk of a capital loss, equity risk, risk related to the capitalisation, liquidity risk, counterparty risk. Under the framework of fund management, additional risk stems from discretionary management, risk related to derivative financial instruments and sustainability risks for funds taking into account ESG criteria.

Article written on 1 March 2021. The information provided is not intended to be investment advice and is to be used for information purposes only. The data used in this document is used in good faith, but no guarantee can be granted in terms of its accuracy. All of the data contained in this document stem from Lazard, unless otherwise stated.

Past performance is not a reliable indicator of future performance. The value of investments and the revenue they generate may evolve upwards or downwards and there is a possibility that investors do not recover all of the capital invested.

For further information, James Ogilvy, Annabelle Vinatier and Jean-François Cardinet, Funds Managers at Lazard Frères Gestion, remain at your disposal.


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