The reason to buy small cap stocks is clear – there is less competition with sophisticated, knowledgeable buyers because small caps are excluded from the major indices. Many fund managers are prohibited from buying small companies, either by mandate or for practical reasons like low daily volumes. If you don't believe me, witness how the Vocus Communications Limited (ASX: VOC) share price spiked to $5 after it was included in the S&P/ASX 300 Index (Index: ^AXKO) (ASX: XKO). My guess is that was the result of those funds that were previously prohibited from buying Vocus, rushing to buy shares. The small-cap investor uses this kind of inefficiency to his or her advantage.
Solid small caps
Some small caps have already proven themselves. For example, there is virtually no chance that litigation funder Bentham IMF Limited (ASX: IMF) will go out of business. It has many years of profitable operation, is conservatively run, has plenty of cash and even grew throughout the GFC. The company's recent expansion overseas is not without risk, but if successful the move will drive profit growth for shareholders for many years to come.
After several years of capital expenditure, the market is finally seeing the value in Tasmanian salmon farmer Tassal Group Limited (ASX: TGR), which has seen its shares soar 115% in the last year. Now that it is completely profitable and stable, Tassal can easily fund further expansion whilst still paying a dividend. Shareholders who bought in early are laughing.
Another small-cap rewarding early shareholders is VOIP telecommunications company My Net Fone Limited (ASX: MNF). It wasn't long ago that a fund manager mentor of mine told me about the little telco. I confess it took me a while to realise the potential for the wholesale division, Symbio, to profit from the proliferation of smartphone Apps like Skype, Viber and WhatsApp. As with Vocus, the company is still guided by its founders. My Net Fone is up 1,083% in 3 years, demonstrating how buying the right small-cap can be immensely profitable.
