In Australia, a small cap company is a company that has a market capitalisation of $50 million to $400 million, generally speaking. This definition excludes all but a few companies that are included in the S&P/ ASX 200.
That's why small caps are often an overlooked corner of the share market. They're excluded from the major indices, and many fund managers are prohibited from buying small companies, either by mandate or for practical reasons like low daily volumes.
What's more – most 'mum and pop' Australian investors simply never hear about these companies because they're not likely to get much media coverage or attention.
So why invest in small cap stocks? Because small cap companies are more likely to experience high rates of profit growth – in Australia and elsewhere.
Capturing the growth of smaller businesses
It makes sense: Expanding a small business is easier than expanding a large one. Put simply, a company that owns one store, and opens a second and equally profitable store, has doubled profits.
However, a company that owns 100 stores, and opens another 20 (equivalent) stores has only increased profits by 20%.
Prices for small cap shares can be more favourable than those of large, widely followed companies too. It's also more difficult to value a fast-growing company than a slow-growing one (in part because initial growth in cashflow has a profound effect on long term discounted cashflow models).
This leads to both undervaluation and overvaluation, giving those with more accurate estimates of value (and the psychology to stick to them) an advantage over sentimental and momentum-driven market participants.
Mouth-watering examples from the ASX…
Looking back at recent ASX history, you can see how top Australian small cap stocks have earned incredible returns for their shareholdes. For example, in 1998 and 1999, Ramsay Healthcare (ASX: RHC) had a market capitalisation of under $200 million. Its founder held 60% of the shares, and its share price suggested that the market expected it to grow.
The company was able to grow earnings considerably thanks to a sound business model, honest and competent management, and industry tailwinds. As a result, the share price grew from $1 at the end of 1999 to almost $40 in 2013.
That's a return of approximately 30% per annum, not including dividends. In fiscal year 2013, the company paid a fully franked dividend of 70c!
Another example of a successful small cap company is TPG Telecom (ASX: TPM). TPG came into existence (in its current form) when SP Telemedia merged with TPG Holdings in April 2008.
For more than a year after that, the company was classified as a small cap, having a market capitalisation of under $250 million.
Washington H Soul Pattinson (ASX: SOL), an early investor in SP Telemedia, owned over 25% of the shares, and the Teoh family (founders of TPG) owned almost 40%.
Today, TPG Telecom has a market capitalisation of over $3.5 billion and the share price has risen from a low of about 10 cents to over $4.50 in the last five years. Investors who bought shares in TPG when it was a small cap company have achieved returns of at least 900% in five years, not including dividends.
Here's another example to consider. It wasn't until 2010 that Domino Pizza (ASX: DMP), one of Australia's ubiquitous brands, clearly lost its small cap status. Even shareholders who bought shares at the worst possible time – the highs of 2006 — have received market-beating returns of about 400%, plus dividends.
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