The allure of small-cap stocks

Small-cap stocks are poised for a resurgence, offering enticing opportunities for investors. However, amidst the multitude of companies, success stories are rare, making careful selection crucial.

The allure of small caps lies in their potential for substantial capital gains.? A standout stock can rapidly multiply in value, delivering significant returns. For instance, Pro Medicus (ASX:PME), an Australian health software company, has skyrocketed over 200 times since 2013, while Afterpay's shares surged from $1 at its IPO in 2016 to over $150 in 2021.

Typically, a micro-cap company boasts a market capitalisation of under $30 million, while a small-cap falls below $1 billion.

Although small caps have trailed larger counterparts in recent years, analysts foresee a rebound, especially with the anticipated decline in interest rates, easing borrowing costs for smaller enterprises.

Professional small-cap investors can reference the S&P/ASX Small Ordinaries Index, which has yielded a 13% capital gain over the past five years.

In 2023, the dominance of the "magnificent 7" stocks heavily influenced S&P 500 returns, accounting for over 70% of the index's total return. Remarkably, merely 10 stocks drove nearly all of the positive return in the S&P 500 for that year. While the significant impact of a handful of large-cap stocks on S&P 500 returns is evident, investors should remain attentive to small and mid-cap stocks, which typically excel during economic recoveries.

Moreover, small and mid-sized companies are poised to benefit from more stable and potentially downward-oriented interest rates projected for 2024. Alongside small caps, investors can also consider cyclicals (value stocks) for 2024, given their heightened sensitivity to economic shifts and comparatively appealing valuations.

Potential concentration risk in ASX 200

Australian investors in the S&P/ASX 200 index and respective funds face potential concentration risk as the local share market reverts to a state where a small cluster of stocks holds sway.

The makeup of the ASX 200 has undergone a substantial transformation in recent months, with the top 20 stocks now commanding nearly 60% of the index's market capitalisation, up from 51% just two months prior. ?Notably, BHP Group (ASX:BHP) alone constitutes 11.5% of this composition.

This level of concentration hasn't been observed since brief periods in 2017 and 2015. Arian Neiron, VanEck's Chief Executive for Asia Pacific, highlights the risks inherent in such concentration, emphasising the importance of diversification for effective risk management.?Any issues affecting these major companies could reverberate throughout the entire market.

Presently, the top 10 stocks in the ASX 200 carry a weight of 45%, with the top five accounting for 32%. This trend has been particularly pronounced recently, with just four companies - BHP, Commonwealth Bank (ASX:CBA), Westpac (ASX:WBC), and National Australia Bank (ASX:NBA) - responsible for 70% of the market gains since February 1, 2024.

Consider an equal weighted portfolio

An alternative approach to investing in small-cap stocks is to opt for equal weight rather than market weight. Equal weight methodology ensures that each stock in a portfolio, index, or index fund holds the same significance, regardless of size. This means smaller companies are given equal importance alongside larger ones when assessing overall performance.

The idea of equally weighting portfolios has garnered attention recently, given the historical performance of small-cap stocks and the emergence of various ETF offerings. Standard & Poor's has introduced over 80 equal-weight indices, incorporating different combinations of market cap, market, and sector.4

Small-cap stocks typically entail higher risk but offer greater potential returns compared to large-caps. In an equal-weight portfolio, prioritising smaller companies within the S&P 500 theoretically enhances the portfolio's return potential. Historically, this has proven true in the short term. For instance, from September 2020 to September 2021, the S&P 500 Equal Weight Index (EWI) delivered a total one-year return of 41.93%, outperforming the traditional S&P 500 Index's return of 33.72%.

When looking for small-cap stock advice, it's best to contact an adviser. Fundamental analysis is paramount for small-cap stock selection, and should have an emphasis on sustained growth in profits and sales over at least five years. Additionally, a robust balance sheet, characterised by minimal debt and ample cash reserves, enhances investment attractiveness.?

Please feel free to contact me if you would like more information about exposure to this investment theme or in regards to your investment strategy in general.

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