No investor will get rich by solely investing in big companies. Commonwealth Bank and Wesfarmers might be solid investments, but they’re certainly not going to quadruple your wealth. Likewise, the chances of BHP Billiton or Westfield Holdings appreciating by 300% over the next decade is slim.

Want to get rich by investing in the sharemarket? Then small cap stocks should form a part of your portfolio. Getting on board Fortescue Metals at $0.03 back in 2003 – the stock is now trading at $6.39 – or JB Hi Fi at $2.10 in 2003, when today’s share price is a whopping $19.59. These are your golden opportunities.

Don’t get me wrong – there is nothing wrong with big, established companies with a proven history of earnings and profits. But it’s the small fries where the big money can be made, and lost.

The market terminology for smaller companies is small caps. The ‘cap’ refers to market capitalisation, calculated by multiplying the number of shares outstanding with the current share price.

The S&P/ASX Small Ordinaries Index measures the performance of small companies in Australia. The largest company in this index holds a market cap of $1.91 billion and the smallest is $20 million. The average market capitalisation of companies in the index is $460 million.

Over the past two years the S&P/ASX Small Ordinaries Index has shot up by over 48 per cent compared to 19 per cent for the S&P/ASX 20, comprising the largest 20 companies on the ASX.

Successful small cap investing is all about finding tomorrow’s stars before the rest of the market catches on. Had you forked out $10,000 on WorleyParsons shares at $1.70 in March 2003, you’d have over $135,000 worth of stock today (WorleyParsons is currently trading at over $23 a share). Whereas a play on Telstra back then would be worth less today.

Put it this way, it’s much more likely for a small company with annual sales of $10 million a year to double or triple earnings over a short period of time (it wins a lucrative contract or expands into new markets) than it is for a large, mature company to boost earnings from $3 to $6 billion a year. And since share prices reflect the future earnings of a company, the share price of your favourite small cap can run quickly when there’s a turn for the better.

One of the pluses of investing in small companies is that it’s one of the rare times when you can beat institutional players such as brokers and fund managers at the game. The illiquidity of small companies means that the majority of fund managers tend to stay clear (the illiquidity of small companies makes it difficult for fund managers to buy enough stock). Therefore it’s possible to get on board a winning small cap before institutional investors start throwing money at it, which in turn tends to push up its share price.

Another related advantage of investing in smaller companies is that, with so little research undertaken by brokers and fund managers, these companies often trade at a discount to their valuation. In other words, many go cheaply.

For reasons such as those outlined above, a number of studies have demonstrated that small cap returns often exceed large cap returns.

So when is a good time to buy small caps for your share portfolio?

Small cap stocks tend to outperform large cap stocks in the first year of a bull market, according to Standard and Poor’s. While the second year of a bull market is also generally positive for small cap returns, by the third year, small caps outperform large caps only about half the time.

The worst time to jump on board the small cap sector is at the tail end of a bull market. As investors become more risk adverse, they tend to ditch riskier small companies in favour of blue chips.

The problem with smaller companies is that they’re often in niche industries, sell a limited number of products and hold more debt – making them more sensitive to rising interest rates. Management turnover, the loss of key executives or contracts can send their share prices into downward spiral.

So choosing wisely before investing and ongoing monitoring is essential if you want to avoid losing money on your small cap investments.

So what are the key ingredients to a winning small cap?

– The stock has consistently outperformed the All Ordinaries Index, and the Small Ordinaries Index

– The company’s earnings consistently exceed market expectations

– The company has a strong brand name or dominates an industry or niche

– Brokers are lifting the company’s earnings forecasts

– It generates a high return on equity (ROE)

–  It’s priced below book value

Likewise, watch out for the following telltale signs of a small cap that could be about to blow your funds:

–    The stock has consistently underperformed the All Ordinaries Index, and the Small Ordinaries Index

–    The company posts earnings significantly below expectations

–    Analysts are lowering earnings estimates

–    Growth in earnings, revenues or profit margins has tumbled in several consecutive quarters

–    The company carries more debt than equity

–    Analysts rate the stock a Sell

–    The stock is a market darling

The best way to manage a small cap portfolio is to mix it up with larger cap stocks. That’s because the small and large cap sectors tend not to move in unison, with large outperforming smalls in some years and visa versa. Rather than attempting to forecast the upcoming cycle, it’s preferable to include a mix of winning small caps and large caps in your portfolio. That way, at every point in time you are able to benefit from the next cyclical upswing.

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