When a share market stops declining and begins to recover, history has shown us that small-caps broadly tend to outperform large-cap stocks - but it's not always that straightforward. Photo / AP
When a share market stops declining and begins to recover, history has shown us that small-caps broadly tend to outperform large-cap stocks - but it's not always that straightforward. Photo / AP
OPINION
By Simon Bradley
When you think about investing, it’s likely the share market will be one of the first things to come to mind. Not all stocks are the same, and when it comes to picking companies to invest in, size matters.
Retail investors, at the start of theirwealth-building journeys, often chase higher returns by investing in small-cap companies or ‘penny stocks’ as they are colloquially known.
Small-cap stocks tend to exhibit more volatility compared to their large-cap counterparts, presenting the allure of higher returns, due to the riskier nature of the investment case.
But large-cap stocks tend to attract more widespread attention by “the street” with research analysts covering the companies. In most cases, there is a plethora of market information around financials, market data and independent research available to investors of large-cap stocks. Conversely, small-cap stocks tend to have limited research coverage in comparison.
Liquidity is a key consideration when it comes to the investment decision-making process. Market liquidity can best be defined as how easy it is to transact in markets without moving prices. Large-cap stocks tend to have tighter spreads - the difference between the current buy price and the current sell price.
Due to better liquidity, large-cap stock prices generally trade with greater efficiency, trading at prices that reflect the underlying valuation of the company and investor sentiment around meeting future earnings expectations.
Small-cap stocks tend to trade with higher volatility due to their riskier profiles and limited access to capital markets, finding it harder to raise funds for future growth.
Despite this, small-cap companies with an edge on the competition or a unique selling point can make for a stronger investment case, as it can be easier for a smaller company to generate proportionately larger growth rates than that of a large-cap company.
Smaller companies often operate more nimbly and can react faster to changes in their operating and regulatory environments.
The regulatory environment impacts large and small-cap stocks, with both susceptible to changes that might occur. Large-cap stocks tend to pay regular dividends to shareholders as their earnings and operating costs tend to be more linear than those of small-cap stocks.
But the investment case for large-cap stocks over small-cap stocks isn’t always that formulaic. Often large-cap stocks see fewer growth opportunities, and large companies can go through periods of turmoil that can result in share price weakness.
Given the recent period of interest-rate volatility, the importance of stock picking cannot be underestimated.
Fears of recessions have historically and disproportionately hit the valuation of small-cap companies.
Large-cap stocks can be more in control of their own destiny due to factors including supply chain pricing power. Photo / Alex Cairns
Similarly, small-cap stocks tend to be more economically sensitive and less liquid than large caps.
To some extent, it’s easier to make a case that large-cap stocks are more in control of their own destiny in times of turmoil given their greater revenue streams and supply chain pricing power.
An investor needs to consider why a company may be trading at what appears to be a cheap valuation. What appears to be an attractive price today might become more so in the future.
When a share market stops declining and begins to recover, history has shown us that small-caps broadly tend to outperform large-cap stocks in the first year following a recession, showing size can matter.
When it comes to predicting the end of a recession, investors and advisers alike don’t have a crystal ball.
Maintaining diversified asset allocation and focusing on “time in the market” rather than “timing the market” remains paramount to successful long-term investing.
Simon Bradley is a Wealth Management Adviser at Jarden.
