As a general rule of thumb, it makes sense to assume that the market is efficient when it comes to larger stocks. Small caps are stocks valued at less than £250m he thinks, but that’s subjective. To an investor looking at a company with a multi-billion market capitalization, a company worth only £1 billion looks incredibly small.
The first reason that almost all of my trades are small caps is because of their growth potential. Small-cap companies are often in the early stages of their growth cycle, giving them more room to grow compared to larger, more established companies. As a result, small-cap stocks can generate higher returns than large-cap stocks, but they are also more risky. For example, many small businesses may rely on external cash injections in the form of repeated discounted equity financing, so the balance sheets and cash flow statements of all surveyed companies Always check for: 1) enough cash in the bank; 2) low burn compared to sustainable cash generation or cash positions.
Small companies are also often understudied. Companies with smaller market capitalizations often don’t get as much coverage from analysts and the media as larger companies, which may increase the chances of finding undervalued stocks that the market has overlooked. Retail investors willing to do their own research may discover promising small-cap stocks that institutional investors haven’t yet focused on. This is why many individuals are drawn to the smaller end of the market, not just the historical performance of small caps.
However, it is important to reiterate that small-cap stocks also carry great risk. They can be more volatile and less liquid than large-cap stocks, which can make it harder to buy or sell stocks at certain times. Individual investors considering investing in small-cap stocks should do their own research to determine whether these types of stocks suit their investment goals and risk tolerance. The advantage of this is the prospect of better returns. For example, a study by Ibbotson and Sinquefield found that from 1926 to 2019, US small caps averaged an annual return of 11.9%, compared to 9.6% for large caps.
That said, it’s important to note that past performance is no guarantee of future results, and there are periods when small-cap stocks underperform. The FTSE 100 has outperformed many of the major indexes this year. Additionally, small-cap performance can be significantly impacted by a variety of factors, including economic conditions, interest rates, and industry trends.
One final advantage of small-cap stocks is the diversification they can offer because they are uncorrelated with the broader market. Because small caps have a better handle on their own destinies, many factors can come into play, but management can adjust more nimbly. Owning 10-15 shares provides good diversification, but still offers good benefits in terms of growth potential.
One stock that I believe has the ability to outperform the market over the next year is Best of the Best (BOTB)Best Of The Best is an online company that offers skill-based competitions where players can win their dream car. You may have run into companies at airports and shopping centers years ago, but now businesses are fully online. I can see the business benefiting greatly from being able to put in more time and have more time. Naturally, people found ways to spend that money. However, with the introduction of Apple’s iOS 14.5, customer acquisition costs skyrocketed as advertising became more expensive to serve and harder to track. The stock issued several gain warnings, ultimately driving the Duke of York down to his 400p.
But if you look at Chart 2, you can see that the stock has risen beyond its 12-month range and then pulled back. I am long on this stock and would like to increase my position if the stock breaks through its recent highs. The company issued £6.275 million in cash in the tender offer, which is not a concern given its excellent cash generation.
The cost-of-living crisis may be a headwind for the company, but while revenue fell significantly in the six months ended October 31, profits remained roughly the same as margins strengthened. After a decline in customers acquired before and after Covid-19, management says the business is now poised for steady growth. Stocks are incredibly illiquid.
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