Which is a better home for your money: big blue-chip companies, or small caps? This Fool has no doubt it's the latter.
If anyone was under the impression that so-called 'blue chips' -- the big, well-known members of the FTSE 100 -- were safe homes for their money, the last couple of years will have disabused them of that notion. As I wrote last week, the credit crunch has turned many large caps into small caps. But are small companies a better bet?
The case for small caps
There are plenty of studies that show small cap returns to be higher, although the effect had diminished to some extent as investors became aware of it.
This can be explained in many ways, one of the more popular of which is the idea that small companies include the pioneering success stories of tomorrow. Small, dynamic businesses can soar in value, while the performance of big, established companies is likely to be more pedestrian. As Jim Slater put it, "elephants don't gallop".
Another possible reason is that small caps are below the radar for most fund managers, analysts and journalists -- it's just not worth their time to look into a company that's only worth a few million pounds. The price of a neglected share is less likely to be inflated, leaving bargains, in theory, for those who want them.
The risks
But are we really exploiting a pricing anomaly, or just getting a higher return for taking on more risk? The fact that a share is neglected by analysts could be considered a form of risk, as we have less information on which to base our decisions.
Small cap prices can be more volatile, although this varies over time. When investors were rushing for the exits over the past year or so, it is certainly true that small caps fell more sharply, and they have also recovered more rapidly in recent months.
Liquidity can be a problem, too, particularly in the extreme conditions we've witnessed. Being unable to sell a share in significant volume when you need to is a major risk factor. Transaction costs, specifically the spread between the buying price and selling price, are higher for small caps, but for longer holding periods this becomes less of an issue.
We can also challenge the idea that small caps are mainly up-and-coming companies. By definition, they can't all make it to the top. And a study on the New York stock exchange showed that new share listings tend to enter the market at capitalisations above the lowest quintile, while the smallest 20% of companies consisted mainly of those that had fallen from grace. Stock-pickers can be selective, of course, but to consider small caps in general to be more dynamic might be a mistake.
These risks are real, and anyone expecting higher returns from small caps has to be happy to live with them.
Why I love small caps
Personally, my preference for small caps comes from the fact that they are easier to understand, and ease of understanding is one of Warren Buffett's key criteria. Yes, they have fewer legs to stand on than large businesses, but also fewer legs to trip over.
The more complex the business, with more product ranges in more markets, the more of my time it takes to understand it, even with the benefit of analysts and commentators. We may get extra points for risk, but investing is not gymnastics -- there are no extra points for difficulty.
Maynard Paton's Champion Shares service offers a carefully selected blend of companies, all the way from blue chips to small caps. You can see what he's recommending right now by taking a free 30-day trial.
