There are many potential dangers with small-caps.
The lure of small-caps is hard to resist for many retail investors -- those tempting little companies with small market capitalisations that can be found in the FTSE SmallCap and Fledgling indices, or listed on the AIM and PLUS markets.
And it's easy to see why, when small companies' share price charts often resemble the electrocardiographic output from a caffeine-fuelled heart beat!
Investors are enticed by the possibility of rapid growth or re-ratings catalysing rocket-like share price rises of the kind that you rarely find occurring for larger, more cumbersome listed companies. That's why there is a vibrant discussion board called Paulypilot's Pub, here at The Motley Fool, which is focused on small-caps.
But, small-cap investing can carry greater risk to match the greater potential reward and investors would be well advised to consider that, before investing.
How Much!
Right at the outset, there are a number of things that can be against the potential small-cap investor.
One of the most prominent of these is the cost of purchasing and selling the shares, due to the often very wide spread between the bid and offer prices. This difference between what you can buy and sell the shares for, at any given moment, can really eat into your profits, especially when combined with other dealing commissions and purchase stamp duty, if it applies.
For example, one popular small-cap trading on the AIM market is IndigoVision Group (LSE: IND), and last time I looked the offer price was 360p and the bid price 320p. This 40p difference equates to a capital loss of 12.5% when you sell, if the share price hasn't moved up. Admittedly, some investors find it possible to trade 'inside the spread' but, nevertheless, the effect of the spread is worthy of consideration.
But it doesn't stop there. These spreads expand and contract according to the level of demand for the shares, market conditions and the whims of the market makers. Sometimes they can be simply huge.
So risk number one, when dealing in small-caps, is that flexible spread.
Locked In
If you want to invest larger sums of money in small-cap opportunities life can become very difficult due to the normal market size (NMS). Restricted liquidity can make it difficult to buy and sell shares in any quantity, quickly, and without negotiation with the market maker.
In other words, it can be hard, and often expensive, to get in, and almost impossible to get out if you want to exit the investment in a hurry. Of course, this may not be a problem if things go well with the company, but if they go badly, you could find yourself 'locked in' to a bad investment.
Risk number two then; restricted liquidity.
Regulation
Investing in companies listed on the FTSE SmallCap or Fledgling indices brings with it the protection of the Financial Services Authority (FSA). These 'fully listed' companies must comply with the listing rules, which the FSA administers; they therefore carry the force of law.
However, if you fancy a tasty little AIM or PLUS quoted company, the situation is a little different, and perhaps a little riskier. These markets are exchange regulated, or to put it another way, self-policed.
In each case, the stock exchange itself is the authority that enforces the listing rules, and despite 'seeking to strike a balance between investor protection and compliance costs', there is a potential conflict of interest, as it is the companies owning the stock exchanges that benefit financially from a company's continued listing.
For the AIM market this is London Stock Exchange Group (LSE: LSE) and for the PLUS market it is PLUS Markets Group (LSE: PMK).
Whereas LSE is profitable with a main market listing, paradoxically, PLUS is a loss-making AIM listed small-cap; that doesn't exactly promote investor confidence, in my view! Despite this, it has big ambitions saying this in a statement issued on 25 August:
"... these initiatives are designed to diversify and increase the revenue base of the Company and to reposition PLUS as a fully fledged competitive London based stock exchange - the PLUS stock exchange"
Nevertheless, if you go for a company listed on an exchange-regulated stock exchange, risk number three becomes weak regulation.
Just The Beginning
So, you weigh up all of these issues and decide to take the plunge with small-cap investing anyway.
Well, that's just the beginning. Holding small-cap investments can often become something of a roller-coaster ride. In an article next week, I'll be recounting some strange tales regarding recent happenings, risks, and opportunities in the world of small-cap investing.
More from Kevin Godbold:
Kevin owns a few IndigoVision shares.
