Paul's Insights: Small companies, big potential

For investors, the challenge is deciding which small companies to invest in out of the hundreds listed on the stock exchange.

Mention sharemarket investing, and our big companies tend to come to mind. But small companies can have plenty of potential for capital growth.

By “small” I don’t mean the local store. There’s no hard and fast rule of what constitutes a small listed company but they typically have a market value below $2 billion. To put that in perspective, the Commonwealth Bank – a goliath of the Australian sharemarket, is valued at $125 billion.

Small companies have had a good run in recent years, with the S&P/ASX Small Ordinaries index reporting total returns (including dividends) of 10.39% over the last three years, and 7.07% over the past five years. By comparison, the ASX 200 index, dedicated to our biggest 200 companies, dished up total returns of 7.69% and 5.83% over the same periods. It’s proof that small companies can outperform their larger counterparts.

The appeal of small companies is that they can be a source of capital gains. These companies tend to be more innovative, and can respond more quickly to changing environments or take advantage of niches in the market.

There are risks too though. A small company may have just one product or service; the business model hasn’t yet been tried and tested; and without substantial reserves to shore up any losses, they can be more vulnerable if a product fails or if their main market tanks.

This is why investors in small companies need to take a long term perspective. After all, today’s sharemarket minnows are the companies of the future.

For investors, the challenge is deciding which small companies to invest in out of the hundreds listed on the stock exchange.

I know that if I gave up golf, sailing and family time, I’d probably find the hours to spend researching small companies. But I’d rather pay a team of experts to do this for me – especially when I can pay fees as low as 0.97% with the likes of investSMART’s Australian Small Companies Fund. That’s well below the fees of around 3% we used to see for small company funds.

It’s not just about how I value my time though. When I choose the companies I want to invest in, I only have my own opinion to rely on. With a professionally run fund I get the benefit of a team of experts, and they’re likely to be better at selecting companies than I am.  There’s a lifestyle element too – I can still enjoy a round of golf or an afternoon on the water knowing that I’m making money on my investments.

Paul Clitheroe is Chairman of InvestSMART, Chairman of the Australian Government Financial Literacy Board and chief commentator for Money Magazine.

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