How to Invest in Small Cap Equities?

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When And Why Should You Have Small Cap Companies In Your Portfolio

First of all what exactly is a small cap company?

Cap refers to the capitalisation of the company. Or in other words the market value of its outstanding shares (share price x the total number of shares outstanding).

Although there is no fixed definition a small cap company is usually regarded as one with a capitalisation of between $300m and £2bn.

So why should you have small cap companies in your portfolio?

The cons are that small cap companies are usually regarded as more risky. But what about the pros?

Small cap companies are usually relatively new rather than established companies – often operating in new or fast developing areas, such as technology – or run by young, ambitious entrepreneurs.

So small cap companies often have high performance and growth potential. For example, a growing small cap company might well be able to grow its sales or profits by ten times over a few years – something unthinkable for a medium or large cap.

Often, very few investors know about promising small cap companies. They aren’t reported on extensively by the financial media. So they slip under the radar of many investors. This means it is possible that their shares could be underpriced.

There is the possibility that you could invest into the ‘next big thing’. You could even be investing in the next Microsoft or Apple!

Also, institutional investors frequently don’t invest in them and so their dealings don’t impact the market for small cap shares. This makes them very much the preserve of astute smaller investors.

Lastly, small cap companies often offer good value and can be regarded as ‘cheap’ using price-earnings and price-earnings-growth measures.

When should you consider investing in small cap companies?

The overall answer here is when you are willing to accept more risk (and volatility) in the expectation of achieving high growth.

However, history has tended to show that the shares of small cap companies tend to perform better in times when the economy is expected to recover. They also tend to perform better in times when interest rates are rising, or are expected to rise.

Of course small cap shares are best regarded as just a part of a diversified and well structured portfolio.