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Smaller companies, even before looking at their type of business, carry additional investment risks. Their shares typically have less liquidity than their larger brethren, which in turn equates to larger spreads. There also tends to be less newsflow from small companies, a situation that can lead to shareholders being left somewhat in the dark. Of course, that is a double-edged sword for the more enterprising investor, who is instead prepared to dig deep for his information.
But perhaps the main problem concerning smaller companies are the positions they usually occupy in their respective marketplaces. If they are competing with, or supplying their services to, much larger companies, then a large dollop of investor caution needs to be applied. Simply because if things become tough for the larger operators, then the smaller companies further down the ladder are likely to bear the brunt of the difficulties.
Two examples of this business phenomenon were shown today, with profit warnings from stock market tiddlers Snackhouse (LSE: SCK) and Ryland Group (LSE: RYG).
Burnt to a crisp!
Snackhouse, formerly known as Benson Crisps, is a manufacturer and supplier of snacks to the food retail market. Recently, the company broadened its range into such delights as dried organic fruit in an effort to "reduce its dependence on the potato crisp market". Until today, Snackhouse was valued at just under £20m and had shown quite a respectable growth record. Since 1996, sales had increased from £32.8m to £48.4m, while operating profits had risen from £2.5m to £3.8m.
This morning, Snackhouse informed its shareholders of a "disappointing interruption to the Group's profitable growth record". The "difficult trading conditions" were said to have been caused by "intense competitive pressures in the UK food industry", all of which have culminated in one of company's major retail customers ending a contract.
With Snackhouse's second-half profits now set to be below expectations, the shares quickly plunged 14p (32%) to 30.5p today.
Car crash!
Ryland are a motor dealer, valued at £14m prior to the company's profit warning. As has been well-documented, the car market has endured all sorts of trouble recently.
Earlier this year, Ryland effectively jumped out of the frying pan and into the fire. The company found they had difficulties shifting BMW and Rover cars and so, in an effort to diversify, bought a few Ford (NYSE: F.) dealership franchises. Today, the company announced the continuing losses from its Ford operation, Ryland highlighting the "adverse impact in the new car profit opportunity" from the US motor manufacturer. And following a recent corporate trend, Ryland also commented on the "hiatus caused by the petrol crisis" that was a "further drain on consumer confidence". Ryland shares shed 8.5p (19%) to 37.5p on the details.
Summary
Both Snackhouse and Ryland exhibited classic value ratings (low price to earnings (P/E) ratios, high dividend yields and so on) prior to the upsets. There are obvious dangers for investors who purely focus on the valuation side of a smallcap company, without due consideration for its competitive position in an industry. A small company, with a heavy involvement with far larger, and troubled, companies, rarely makes for an enticing investment proposition, whatever the valuation is implying. Thus, when it comes to long-term share purchases of smaller companies, a market dominant position or a truly sustainable competitive advantage really must be sought.