Small cap is the ultimate variety box for stock pickers

Updated: 
Hotel Chocolat

Investing pundits typically paint smaller companies - or small caps - with a very broad brush.
 
So broad, in fact, they often drown out the variety at the tiny end of the market.
 
For example we're told small caps have delivered much greater returns over the long-term than the largest companies, but that in the short-run they're more volatile, and their returns more unpredictable.
 
Small caps are more likely to go bust, too, or at best be acquired for a song.
 
After the EU Referendum, we were told that the FTSE 100 was outperforming mid- to small-sized companies because the big boys were multinationals, and so better able to shrug off local difficulties and to benefit from a falling pound.
 
And all that's true enough.

Small companies, big returns

But like most stereotypes, while there are kernels of reality amongst the generalisations, they skip over an awful lot of particularity.
 
So yes, by most measures small caps handily outperform. Between 1955 and 2015, for example, the Numis Smaller Company Index delivered a 15.4% annual return, compared to 11.7% from the large-cap dominated FTSE All-Share.
 
That 3.7% difference makes for a staggering difference when compounded over decades. It confirms small caps' reputation for big gains.
 
Indeed, the smallest firms have done even better. Numis calculates the UK's listed minnows would have delivered more than 17% over that period.
 
But the fact is there were no index trackers in 1955. You'd have had to buy individual small caps via expensive brokers at large spreads, and that could well have curbed these returns.
 
How relevant then is the older data, really?

Missing the target

Also, despite the big gains of small caps as defined by Numis, you often hear horror stories from investors who've been burned looking for hot small caps.
 
The Alternative Investment Market, or AIM, has been a case in point.
 
In 2015 the Financial Times noted:

Investing in small, unproven companies is inherently riskier than backing larger, more predictable ones, and AIM's annualised total return of -1.6 per cent a year when measured over the past two decades is hardly cause for celebration.

Two decades for a negative return? Hardly the gains you'd have hoped for!
 
AIM can be a tricky market, for reasons we'll save for another day. But it's also been a popular one with private investors, attracted by tax breaks as well as the profusion of small companies with great stories.
 
Sadly, after seeing too many stories go sour - or bust - many investors swear off so-called "penny stock" investing forever.
 
I'd argue it was the investments went wrong, not the small cap asset class.

Big bust ups

 Smaller companies in general are riskier, yes. Common sense would suggest that.
 
But larger companies are hardly immune from bankruptcy.
 
Sticking with AIM, former darlings like ScotOil, African Minerals, and Izodia ballooned into billion pound companies... before going bust.
 
Blue chip collapses such as HBOS and Northern Rock have further reminded us size does not confer invulnerability from disaster.
 
Then there's the idea of penny shares, which I suspect has come to us from the US. Regulators there designate companies with a share price of less than $5 as penny stocks. Investors are warned they're more speculative, illiquid, and risky
 
Yet a low share price doesn't mean much in Britain. The biggest UK companies often prefer to have relatively modest share prices. They may issue new shares to achieve this.
 
BP(LSE: BP) is one of the largest companies in the world, but its shares only recently breached £5.
 
LloydsBanking Group(LSE: LLOY) is a FTSE 100 company with a market cap of £45 BILLION. Yet its shares trade for 65p a pop!
 
Don't avoid a company just because of a low share price.

Small wonders

The most important thing to know, though, is that in aggregate smaller companies may demonstrate certain tendencies, but individually they are hugely varied.
 
One large multinational can seem much like another. Small companies are all snowflakes.
 
Consider these small caps bucking the prejudices:

Unpredictable? - Brewer Young & Co's (LSE: YNGA) has increased its dividend payout every year for 19 years. A steady dividend is not hugely unusual among London's smaller family-founded firms.
 
Domestically focused? Laser-guided equipment maker Somero Enterprises(LSE: SOM) earns 70% of its revenues in North America, and nearly 10% in China.
 
Volatile? Shares in construction firm and commercial landlord J Smart(LSE: SMJ) haven't traded more than 5p other side of 105p for the past 12 months. If that share price graph were an electrocardiogram, the nurses would be pulling off their gloves and turning down the lights.
 
Fly-by-night? London-based Mountview Estates(LSE: MTVW) has been trading residential homes in the capital since 1937. It's still managed by the founding family. Don't talk to it about property boom and bust.
 
Boring? Specialist tonic pioneer Fevertree Drinks (LSE: FEVR) is now worth more than £1.3bn, but when it listed on AIM five years ago it was valued at less than £200m. Clink!

For stock pickers with the time, interest and skill to discern the best from the rest, small caps offer unrivalled variety - as well as the prospect of super gains.

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Owain own shares in BP and Lloyds Banking Group. The Motley Fool owns shares in Mountview Estates, and has recommended shares in BP and Somero Enterprises.