By investing in small caps, the odds are more in your favour.
This article is part of our Duelling Fools feature on 'Blue Chips vs Small Caps'. Read the intro, the case for blue chips and then cast your vote here.
When I think about the blue chip versus small cap debate, I have to ask myself the question: What exactly am I doing when I buy shares? If I'm buying individual companies, my aim is clearly to outperform the market, otherwise I should just buy the market using a tracker.
Neglected shares
And if I intend to outperform the market, I need to find pricing anomalies -- situations where the market has mis-priced the risk of owning a share, and mis-priced it in my favour. But where can I find these elusive opportunities? I believe the odds of finding such bargains are considerably higher amongst the neglected and ignored small caps, than amongst the closely-watched and deeply-analysed blue chips; if all the information is widely known, it's more likely be factored into the price already.
So rather than swanning around in the exalted atmosphere of the FTSE 100, I get to poke some rather whiffy companies with a stick, in the hope of finding a few that will jump up and start to run. I can see why that scares people away. But my argument is not that small caps as a group are better than blue chips as a group -- although some academic research suggests that they are -- but rather that the real racers that I'm searching for are more likely to be found within that small cap category.
Size matters
This is partly due to being neglected by analysts, but also due to their size. As Jim Slater famously said, "elephants don't gallop" -- a £50m company is more likely to multi-bag than a £50 billion company.
Risk and reward
And don't assume that a company is safe just because it's a blue chip. While I have to admit that having the eyes of the world on it is likely to make it safer in terms of corporate governance, we shouldn't forget the blue chips that have crashed and burned over the years: Royal Bank of Scotland (LSE: RBS), Marconi, Enron, Worldcom, General Motors … even Royal Dutch Shell (LSE: RDSB) had to admit it had been overstating its oil reserves, and what could be more keenly followed than that?
Which is not to downplay the risks of owning small caps. They can be hard to buy and sell in volume, which is especially risky if you really need to sell. And the difference between the quoted buy and sell prices, the 'bid-offer spread', can be very significant, although for long-term investors it's not such an issue. For that reason, I am not promoting the extreme end of the spectrum, the micro caps about which I've warned in the past, but where one draws the line can be a bit arbitrary.
Re-rating
The good thing is that if you've chosen correctly -- a big 'if', I know -- then these downsides of small caps start to fall away, and the shares become re-rated as the company become bigger, better known, and more actively traded.
Simplicity
We can argue about whether the cheapness of small caps is just a reward for taking on greater risk, but for me the real clincher is the relative ease with which we can get to grips with their businesses and stay up to date. Smaller companies typically have fewer businesses spread over fewer countries and currencies than blue chips, and that makes them easier to understand. News-flow will be slower too, so less time needs to be spent reading and considering whether to sell.
We don't just invest money, we invest time, and there's never enough of it to go around. Taking a 'total cost of ownership' perspective, everything else being equal, I'll go for the investment that requires less of my time. You don't get an extra return for the extra effort required to keep up with the reams of information and opinion available on blue chips.
Why small caps are better
So there you have it -- small caps are:
- neglected, so less likely to be properly priced by the market, thus allowing us to find bargains;
- not too big to gallop;
- capable of shedding their small cap disadvantages (liquidity, bid-offer spread) as they grow;
- easier to understand; and,
- less time-consuming to follow.
To flog the animal metaphor one more time, it's horses for courses, and for me the small caps win by a length.
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