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Are small cap shares the best place to invest?

Small cap stocks have been losing their gloss recently with the sector underperforming their bigger brothers in the last few months after a blistering FY18.

But some experts believe small caps are well placed to make a big comeback during this month’s reporting season and history seems to be on their side!

The S&P/ASX SMALL ORDINARIES (Index:^AXSO) (ASX:XSO) index has fallen 0.4% since the start of FY19 when the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) is ahead by 1%. This reversal comes after small caps posted a 21% surge in the last financial year, versus a 9% gain by the top 200 benchmark.

Small caps could retake the crown later this month though as Bell Potter’s trading desk stock guru Richard Coppleson points out that these market minnows do better than stocks on the ASX 200 in the August reporting season.

He also points out that the reversal of fortunes is not confined to small caps. You only need to look at the recent rebound in the share prices of FY18 dogs like Telstra Corporation Ltd (ASX: TLS), Ramsay Health Care Limited Fully Paid Ord. Shrs (ASX: RHC), QBE Insurance Group Ltd (ASX: QBE) and Australia and New Zealand Banking Group (ASX: ANZ) to see what I mean.

Some believe this won’t last as bargain hunting will give way to quality when companies lift the earnings curtain and expose themselves to the market this month.

Further, the shares of small caps are more volatile. Any pleasant earnings surprises will spark a bigger share price run than among the large cap stocks.

Given the reasonably positive trading environment over the past year or two, despite signs of weakness in some areas of our economy like housing, there should be more opportunities for companies to produce good news than bad.

What this means is that you can’t write off small caps that have outperformed in FY18 but have struggled since. These include omega-3 encapsulation technology company Clover Corporation Limited (ASX: CLV), Bubs Australia Ltd (ASX: BUB) and Kogan.com Ltd (ASX: KGN) – just to name a few.

But there’s something that could spoil the comeback party for small caps, in my view. It’s our late cycle bull market.

Growth stocks have dominated the league table over the past year or two, while value stocks trading at a discount to the market have lagged.

We almost always see a reversal when a bull market gets long in the tooth. The small caps sector is largely dominated by growth stocks, not value.

When investors’ preference changes (and it’s a question of “when”, not “if”), the junior end of the market will almost certainly lag.

However, the experts at the Motley Fool believe a niche group of smaller companies are likely to keep outperforming, regardless of the market cycle.

Follow the free link below to find out why.

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Motley Fool contributor Brendon Lau owns shares of Australia & New Zealand Banking Group Limited and Telstra Limited. The Motley Fool Australia owns shares of and has recommended Telstra Limited. The Motley Fool Australia has recommended Kogan.com ltd and Ramsay Health Care Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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