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Why you should consider ASX small cap investing

A perfectly adequate strategy for some investors is just to invest in a simple exchange-traded fund (ETF) such as Vanguard Australian Share ETF (ASX: VAS).

But by doing that you would miss out on investing in ASX small caps. I think there are plenty of reasons why I think you should consider investing in small caps:

Growth potential

Many of the largest businesses on the ASX such as Commonwealth Bank of Australia (ASX: CBA), Telstra Corporation Ltd (ASX: TLS) and Woolworths Group Ltd (ASX: WOW) have reached a very mature stage of their growth. Their revenue isn’t going to grow very fast for the foreseeable future.

However, smaller businesses have the potential to create much more growth as they deliver on their potential in Australia and other countries.

International diversification

Most of the underlying earnings of the big ASX businesses are generated from Australia (and New Zealand). That is very country-specific earnings. 

Meanwhile, you can find smaller Australian (or Kiwi) businesses that generate a much larger portion of their earnings overseas such as Pushpay Holdings Ltd (ASX: PPH) and Volpara Health Technologies Ltd (ASX: VHT).

Indeed, you may find foreign businesses that just happen to have a listing on the ASX such as CYBG Plc (ASX: CYB) and ResMed Inc (ASX: RMD), although I wouldn’t count them as small caps.

Potentially lower valuations

These small businesses may also be trading at a lower multiple of their earnings due to the fact that they are not followed by many investors, despite the potentially better growth prospects. 

For example, Propel Funeral Partners Ltd (ASX: PFP) and InvoCare Limited (ASX: IVC) both operate in the funeral business, yet InvoCare generally trades at a higher multiple of earnings.

However, there are some large businesses that are just so excellent and have a strong economic moat that they could continue to be winners for years to come and are worth the premium. There aren’t many examples of these on the ASX, but CSL Limited (ASX: CSL) and REA Group Limited (ASX: REA) are two that come to mind.

Foolish takeaway

The key problem is identifying which ASX small caps are worth buying, which is why I’m happy to leave the selection to fund managers I respect such as WAM Microcap Limited (ASX: WMI) and Naos Emerging Opportunities Company Ltd (ASX: NCC). However, there are plenty of opportunities out there. 

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Tristan Harrison owns shares of InvoCare Limited, Propel Funeral Partners Ltd, and WAM MICRO FPO. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of CSL Ltd. The Motley Fool Australia owns shares of and has recommended PUSHPAY FPO NZX, Telstra Limited, and VOLPARA FPO NZ. The Motley Fool Australia has recommended InvoCare Limited, Propel Funeral Partners Ltd, REA Group Limited, and ResMed Inc. 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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