Small-cap stocks can have significant growth potential – after all, many large-cap stocks started their professional lives as speculative small caps. And when the value of a small-cap share increases, so does the wealth of its (particularly early!) investors.
But always remember – with greater potential upside comes greater risk! This means small-cap investing may not suit everyone.
In this article, we'll help you decide whether small caps might be worth considering for your share portfolio.
What are ASX small-cap shares?
A small-cap stock typically has a market capitalisation ranging from a few hundred million to $2 billion. The benchmark for ASX small caps is the S&P/ASX Small Ordinaries Index (ASX: XSO). It represents 200 companies ranked 101-300 in the S&P/ASX 300 Index (ASX: XKO).
Analysts and the media typically cover large-cap shares more rigorously than small-caps. Smaller companies generally aren't household names, which means they don't draw as much focus from the media.
They also may be too small for mutual funds to invest in, as many managers won't buy into a company until its market capitalisation reaches a minimum level. This means analysts won't devote much time to looking at them either because institutional investors aren't as interested.
Because less information about small caps is available, it necessarily makes investing in them more speculative and uncertain. These companies are unproven, and there is a lot about them we just don't know yet.
There's the chance they might surprise the market and become incredibly successful overnight — but it's also possible they'll fail to make a lasting impact in their industry and go out of business. This makes investing in small caps inherently more risky than investing in larger, more mature companies.
Why invest in ASX small-cap stocks?
Small-cap shares are potentially the large-cap shares of the future!
Generally younger companies than those in the S&P/ASX 100 Index (ASX: XTO), small-cap companies may have greater growth prospects than their larger peers, which have already matured. But they also tend to be more volatile than larger-cap stocks, meaning their share prices fluctuate more.
Most of the approximately 2,000 companies listed on the ASX are small-cap businesses. This means there is an incredible variety of small caps for investors to choose from, making finding those few diamonds in the rough especially difficult. But those small caps that do make it can reward their investors with significantly higher share price appreciation than large-cap stocks.
Below are three top small-cap shares ranked by market capitalisation from high to low. All have significantly outperformed the ASX 100 index over the past five years.
Top small-cap stocks on the ASX
|NIB Holdings Limited |
|A health and travel insurance provider giving cover to more than 1.5 million Australian |
and New Zealand residents
|TechnologyOne Ltd |
|An enterprise software company that provides a software-as-a-service (SaaS) |
business resource planning solution
|Life360 Inc |
|Information Technology company headquartered in California specialising in |
This company is Australia's third-largest travel insurer and a global travel insurance distributor. NIB Holdings provides insurance coverage to more than 1.5 million Australian and New Zealand residents. It also covers more than 180,000 international students and workers in Australia.
In late 2022, NIB raised $150 million to fund its entry into the National Disability Insurance Scheme (NDIS) Plan Management. Plan managers are providers that support recipients of NDIS funding to manage their funding.
NIB has begun entering the market via acquisitions, which makes it a particularly exciting small cap to watch. It recently acquired its sixth provider (in under a year) when it snapped up BudgetNet, a Victorian plan manager with more than 5,000 participants. NIB states it is on track to meet its target of 50,000 NDIS participants by 2025.
TechnologyOne is Australia's largest enterprise software company. It provides a global software-as-a-service (SaaS) enterprise resource planning solution available on any device, anywhere, at any time.
With a 35-year history, the company provides enterprise software that evolves and adapts to new and emerging technologies. More than 1,200 corporations, government agencies, local councils, and universities use its software.
In 1H23, TechnologyOne reported its 14th straight year of record first-half profit, revenue, and SaaS fees. With the SaaS business growing faster than expected, TechnologyOne is on track to surpass its target of more than $500 million in annualised recurring revenue (ARR) by FY26.
The company now has subscriptions from more than 900 large-scale enterprise organisations, with millions of users leveraging its software for mission-critical activities. This makes TechnologyOne the most significant single-instance SaaS enterprise resource planning (ERP) offering in Australia.
Life360 is a smartphone app that allows users to share their locations with one another. Although that might sound a little creepy, Life360 markets itself as a 'family safety service' that provides its customers with security and peace of mind.
Users can save particular locations, like their home, office, or children's school, and be notified whenever their family members arrive there. The app also allows users to navigate directly to their loved one's location without needing their address. Aren't you disappointed your parents didn't have this sort of peace of mind when you were a teenager?
The app does have some other nifty safety features built in, too. For example, by tracking users' locations, it can analyse their driving behaviour and provide feedback, turning them into better drivers. And if they have a crash, it will automatically send for help.
The company has snowballed in recent years and now has 54 million global active monthly users – 1.6 million of them right here in Australia.
What to look for when investing in small-cap shares
Investors in small-cap shares are looking for growth potential. This means they will seek revenue and earnings growth and a large addressable market. Revenue growth is significant for small-cap stocks because younger companies should be able to deliver higher revenue growth than larger, more mature companies.
As companies mature, earnings need to grow so they become profitable. Small-cap stocks may not yet be profitable, but ideally, losses should be narrowing. Many investors use the price-to-earnings (P/E) ratio to indicate whether a stock may be over or undervalued.
Finally, for a company to grow, a good market for its products and services must exist. A larger market means there are more opportunities to generate revenue.
Pros of investing in small-cap shares
Growth potential: The law of large numbers makes it more difficult for companies to grow as they become bigger. This means small companies have, by definition, greater growth potential than large-cap companies.
Capital gains: Small-cap shares that graduate to large-cap shares can deliver returns in many multiples to investors.
And the cons
Volatility: The share price of small-cap shares can fluctuate to a greater extent than that of large-cap shares during market upturns and downturns. This makes them less ideal investments for nervous investors (or those seeking a more reliable source of income).
Risk: Investing in smaller companies can be higher risk as their balance sheets are not as strong as those of larger companies, and they may not have access to the same lending.
Are ASX small-cap stocks a good investment?
Whether ASX small-cap stocks are a good investment for you will depend on your financial situation and investing goals. Small-cap shares have the potential to deliver outsized returns. But higher potential rewards come with a heightened degree of risk.
A small-cap company will have a different level of capital than mid-cap stocks and large-cap stocks. This means their financial resources to keep the company running and growing are more limited, leaving them more vulnerable to failure.
Small-cap shares also tend to be less liquid than larger-cap shares, meaning it may take more time to sell them at a price that reflects their value. Nonetheless, their potential for outperformance means small-cap shares can help boost returns in a well-diversified portfolio.
- Additional reporting: Rhys Brock