ASX small-cap shares can deliver wonderful returns for investors who are brave enough to look at them. In fact, in 2024, I'd rather buy smaller businesses than ASX blue-chip shares.
Don't get me wrong, I think the ASX has many quality, large businesses such as Wesfarmers Ltd (ASX: WES), Washington H. Soul Pattinson and Co. Ltd (ASX: SOL), Sonic Healthcare Ltd (ASX: SHL), Brickworks Limited (ASX: BKW) and Xero Limited (ASX: XRO).
And I'm not suggesting that every small-cap will do well — I don't usually look at a business with a market capitalisation of less than $100 million.
But if I want to achieve stronger returns (and I do), I think some of those smaller names could be good ideas for a few different reasons.
1. Growth potential
Smaller businesses are typically much earlier in their growth journey than blue chips.
To give ourselves a good chance of beating the market return, I think we need to see potential revenue/profit growth that's faster than the market's growth over a longer time period (such as three or five years).
It's much easier for a company to double its revenue from $10 million to $20 million than it is to go from $1 billion to $2 billion.
Every business has a growth ceiling – once it reaches a certain level, volume growth can slow (and be limited to population growth and inflation). The earlier we can identify these businesses with strong growth potential, the better the shareholder returns may be.
Bear in mind that every big business was small once, including stocks like Amazon.com and Microsoft. But we can't know for sure if an ASX small-cap share will do well, and it can take years for the growth to play out, so patience is critical.
2. ASX small-cap shares are under-researched
Many analysts and investors typically follow the performance of ASX blue-chip shares. This means the market rarely undervalues these companies by any significant amount. There aren't many major surprises.
But, a significantly smaller number of people are analysing those ASX small-cap shares, so they have less public attention and coverage. This can sometimes mean they trade on an attractive price/earnings (P/E) ratio even though they have a much larger growth runway ahead of them.
I like finding ASX shares where the market underappreciates a company, and the smaller end is the right place to look, in my opinion.
When a stock has a relatively low P/E ratio, it can also lead to a solid dividend yield. I was able to buy Altium Limited (ASX: ALU) shares roughly a decade ago with a dividend yield of more than 3%, simply because it wasn't priced for how much growth it was about to achieve.
3. Takeover potential
As a bonus, a takeover offer can suddenly appear, rapidly increasing the return.
There have been a number of ASX shares that I liked which received (and accepted) takeover offers, including Volpara Health Technologies Ltd (ASX: VHT), Pushpay and Healthia. If the overall market doesn't recognise the potential, a bidder may swoop in and deliver the returns we're looking for.
Plenty of ASX small-caps have seen their share prices lift in the last few months, so there may not be as many cheap opportunities today. But I think there are still more than enough if you do your research.
