How do I invest in small caps?

While the general consensus is that it’s best to begin by investing in large, well established companies, that doesn’t necessarily mean that smaller alternatives need to be ignored.

Companies that are listed on a stock exchange like the ASX can be categorised according to their size, which is most frequently measured by market capitalisation, or market cap.

A market cap is calculated by multiplying the number of shares on issue by their current market price.

If a company has 50 million shares that are worth $5 each, its market cap would be $250m.

The market cap is an ever changing number and is more a reflection of a company’s perceived worth in the eyes of investment markets, rather than its fundamental value.

How to invest

The S&P/ASX Small Ordinaries index represents ‘small caps’, those members of the S&P/ASX 300 Index that sit outside the S&P/ASX 100 index.

It is a benchmark for small cap Australian shares.

These may not be what you’d consider as small companies, however. The index includes JB Hi-Fi, Dulux Group and Seven West Media, for example.

The S&P/ASX Emerging Companies index has much smaller ones, known as ‘microcap’ stocks, with market caps as little as $13m.

You can buy small and emerging companies in the same ways that you can buy any other shares, either directly through a broker, or through a fund.

If you want some exposure to the performance of small cap stocks but aren’t sure which specific ones, you could invest in a managed fund, or an exchange traded fund that tracks an index of small cap shares.

Small cap benefits

• More growth potential than large caps, as they’re at an earlier stage of development
• Add diversification to your portfolio with different growth drivers and risk exposures
• Easier to find undervalued shares as they get less focus from investors

Small cap risks

• Liquidity - traded less so it can be harder to find a buyer if you want to sell
• This can also cause a larger bid/offer spread so you might have to pay a larger premium on the current market price to buy shares
• Less diverse revenue streams mean bigger risk of falling earnings and profit
• Smaller dividends, if any at all, as companies need to invest spare funds to grow