Small company investing often means a bumpy ride

Software company Xero started out in an apartment and now has a market cap of A$6.2b. Photo / Getty Images

COMMENT:

Big things come in small packages. Unfortunately, that includes big risks.

A small listed company is a seed of growth or danger and it is often difficult to tell which. Small companies don't always get the attention.

But the investors who love them, and many do, hope these small - if not always perfectly formed - packages produce a butterfly. Not a jack-in-the-box.

The transformation story is part of the appeal of small companies. Large companies have outgrown, and perhaps deviated from, their origins. Small companies are still living theirs and investors can experience it with them.

It's not just narrative appeal. Small companies also deliver financial results. All investing is fundamentally about buying cheap and selling dear. And small companies which grow, ideally rapidly and for a long time, can be very good at that.

This has been a feature of markets for a long time. The Russell 2000 index (the most widely-known index of small US companies) has outperformed the S&P 500 (the most widely-known index of large US companies) on an annualised basis since 2002. This hasn't happened every year.

The S&P has outperformed over 10, five and three years. But in the last two years the Russell has come back .

The pattern is strong in New Zealand, too. The S&P NZX Small Cap Index has outperformed the S&P NZX Gross 50 Index since 2002, 2005, 2008, 2013 and 2015. In Australia, the S&P ASX 200 has outperformed the S&P ASX Small Ordinaries Index in most periods - until the last three years.

Xero is a good example of the joy and pain of investing in small companies. Xero began in an apartment and listed on the NZX in 2007 at $1 a share with a sharemarket value of just $55 million. It hit a low of 0.68c per share in January 2008. It's now on the ASX, at A$44.42 per share and a market cap of A$6.2 billion ($6.8b).

Those bald facts give a good story. But the bridging chapters from apartment to A$6b took capital raisings, new independent directors, a hedge fund, continuous scepticism about operating revenue and leaving the NZX for the ASX.

Like the growth trajectories of most small companies, the upward journey for Xero has been as much rollercoaster as rocket. Exhilaration and queasiness for management and investors alike.

Investing in small companies takes application, judgment, faith and luck.

Small companies are little known. Or unknown. Market confidence in small companies is slow to build (until it isn't, for example when they finally get on larger investors' radars) and quick to unravel.

Investors in small companies look for four things and rarely find all of them.

First, a strong position in their market and plenty of room to grow. This might be because they are the best operator. It could be because they're the only operator, perhaps because no one else wants to or can do what they do. Perhaps because no one else has thought of doing it yet.

Second, a strong management team which is a good bet for keeping the advantage they have, or just working harder and smarter than competitors.

Having a founder with substantial money in the business is also important. If they're a big investor, they want the same things as other investors. Growth.

Third, a healthy financial position. Not too much debt, ideally none. The financial raw materials to fund growth through acquisition or investing in their business.

The fourth doesn't have to be present but, in some market conditions, is sometimes enough on its own. Markets go through cycles and, in some cycles, certain companies do well.

For example, mining companies. If commodity prices are heading up, they don't have to be the best or biggest operator to benefit and for investors to benefit alongside them. This requires good timing and a disciplined approach to getting out, but it can work.

Finding and evaluating these qualities is how the small company investor generates their ideas. But even when you find a great company, investing can be tricky. For one, the founders can hold a lot of the company. This is great for alignment but not so good for getting enough of the shares yourself (or for selling them when you want to).

The investor must also keep in mind the market fragility mentioned already. Small companies' prices can react more savagely to bad news or just what's seen as bad news. Returns from small companies tend to be far more volatile (a lot of volatility is cruising just beneath the surface of those long-term returns for small v large company indexes).

This requires watchfulness and managing risk, first by the size of your investment and by what news you respond to and how quickly.

For a small company a plunge in the share price could be short-lived turbulence and a buying opportunity, or could herald the first stage in a far worse and enduring death spiral.

But if you choose carefully, don't fall in love with them too much, are patient and can hold your nerve through the bumps, small company investing is rewarding.

- Mike Taylor is the chief executive of Pie Funds.