How To Buy Australian Small Cap (ASX) Stocks: Explained

 

The ASX presents abundant small-cap opportunities. With over 2,000 companies listed on the exchange, more than 70% are categorised as small-cap stocks, boasting a market capitalisation below $200 million.

 

Small-cap stocks offer significant growth potential, but it's essential to acknowledge that they come with higher risk. Despite the risks, they have the potential to deliver financial gains through dividends and stock price appreciation as they continue to grow.
 

This blog explores what small-cap stocks are, why people buy them, the pros and cons, how to invest them, and much more.

 

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1. What Are Australian Small-Cap Stocks?

 

Small Caps are also known as Penny stocks, Emerging Companies, Growth Stocks, or Micro-Caps. They are low in price and cost only a couple of dollars.

 

These stocks have a market capitalisation ranging from a few hundred million dollars to $2 billion. The benchmark for ASX small caps stocks is the S&P/ASX Small Ordinaries Index (ASX: XSO). It signifies 200 companies in the S&P/ASX 300 Index (ASX: XKO).

 

Due to their small size, fund managers and institutional investors are only interested in buying them once the company's market cap reaches a minimum level. That's the reason they are less appealing to them.

 

 

2. Why Should You Buy A Small Cap Stock?

 

Investors find small caps more advantageous than mid-cap and large-cap stocks for the following reasons:

 

• They possess the capacity to deliver rapid growth, and when it comes to larger companies, they are unparalleled. Excellently managed and fundamentally robust small companies have significant potential for price appreciation. While blue-chip stocks may experience modest growth of around 5%, investing in a high-quality small-cap stock can yield returns of 20% to 30% within a reasonable timeframe. 

 

• The business is usually less complex than large caps.

 

• Small-cap investments help you generate additional income through dividends. Around 50% of ASX-listed Small Cap stocks share their profits through dividends.

 

• Many are cheap, costing below $5 to buy, so you can begin building a portfolio over time without spending much. Moreover, small-cap stocks offer cheap diversification. You can spread your money in 4-5 high-growth stocks to lessen your risks and position your portfolio for success.

 

• Achieving wealth is possible (not guaranteed) by investing in stable companies trading at fair prices and retaining those investments until they transform into large corporations that attract significant interest from big investors. Remember, they are also riskier stocks, which could lead to quicker losses.

 

• Small caps can thrive in any market. Where larger companies cut back on innovation during economic downturns, small caps operate in under-explored and uncompetitive industry niches.

 

 

Always seek the help of a professional financial advisor before making any investment decision. Investing carries risk. The above are just some general options for educational purposes. All these options come with risk. This is not financial advice.

 

 

 

3. How Do You Buy Small-Cap Stocks In Australia?

 

Small-cap investing is about 'betting' on an undiscovered stock that is about to get significant exposure soon and may even transform into a large cap in a couple of months.

 

Here are the steps to help you buy your first small-cap stock:

 

 

Step 1: Find A Broker To Buy Small Cap Shares

 

Buying a small-cap stock is similar to purchasing any stock on the ASX. You will need a broker offering the services to trade in small-cap stocks. 

 

But before you start, you must have an account with a broker to buy and sell small-cap shares. If you still need a share trading account, consider eToro, which is used by many investors in Australia and worldwide. You can create an eToro trading account HERE.

 

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Step 2: Create A Shortlist And Analyse Stocks

 

Next, you must analyze and shortlist the stocks based on the Financials, Revenue Growth, Price-To-Earnings (P/E) Ratio Earnings Growth, Management, and Past Price Appreciation.

 

 

Step 3: Prepare a Trading Strategy to Execute Your Trade

 

After deciding on the right small-cap stock, prepare a trading strategy.

 

It will help you maximize your gains when your trading system goes right and minimize your losses when your system goes against your projection.

 

 

Step 4: Choose A Time To Execute Your Small-Cap Trading Strategy

 

It is the period you will require to analyse the share, arrive at conclusions, and assess whether or not it is worth a punt. It is a way to set realistic expectations over time.

 

You can identify long-term money-making opportunities by investing in promising small companies with a 5-year plan to launch an innovative service or product to market.

 

 

Step 5: Decide The Number of Small-Cap Shares You Want To Buy 

 

Don't invest all of your money in one stock, as this is a very risky strategy.

 

It is always good to pick two to four stocks to spread the risk.

 

 

Step 6: You Need Trading Discipline

 

It helps you stay focused and adapt to market conditions. Before entering a trade, clearly understand each trade's potential rewards and risks.

 

Fix your entry and exit targets and leave the trade once they are hit. Keep strict stop losses and stick to them to curtail your losses.

 

 

 

Step 7: You Are Read Now To Place The Buy Order

 

Once you have decided on the below, you can place your first order.

 

• Your return on investment expectations

• The maximum risk you can take

• Position sizing, stop-loss

• Profit-taking rules

 

 

4. What Are Risks Associated With Small Cap Stocks?

 

Having talked about the benefits of buying a small-cap stock, now let us look at the risks they may present you:

 

• Liquidity is the primary concern with small caps. It may be harder to trade in these shares due to low availability on the market.

• Small companies have limited financial resources for their operation and growth, making them more prone to failure. 

• When buying small caps, you should be ready to face the extremes on both sides. Small caps give you massive gains when the market sentiments are favourable; however, bad news can drastically affect the stock price.  

• These stocks are under-researched and rarely in market news, so you must do extensive research before buying to avoid losses due to wrong selection. 

 

 

5. How Do You Find Small-Cap Stocks In Australia?

 

Only some small companies have the potential to outperform in the future. That is the reason you need to learn how to pick small-cap stocks. Carefully assessing each stock before buying requires time, experience, and enthusiasm.

 

Here are a few metrics to keep an eye on:

 

 

• Business: Understand the company's business, core activities, and industry functions. Find out its 'unique selling proposition.

 

• Financials: Look at the company's balance sheet to understand the company's fundamentals and financials. Check their cash flows and reserves, existing loans, growth percentage, and shareholding pattern. Ensure the selected company is the leader in its industry segment and among its peers.

 

• Revenue Growth: Check their sales and revenue growth over the past years. Budding companies can deliver higher revenue growth than larger and mature companies. Look for a stock with revenue growth above 20% and a track record of consistent revenue growth.

 

• Price-To-Earnings (P/E) Ratio: The timing is crucial when buying any stock. You can check whether the company is overvalued or undervalued by checking its P/E ratio. Where a lower ratio indicates a company is a bargain, a higher ratio suggests it's expensive.

 

• Earnings Growth: Earnings growth is again worth considering factor when analysing small-cap companies for investment. Though these stocks may not have profits, their net income should trend upward to narrow losses.

 

• Management: Look at how trustworthy, reputed, and experienced the management is. A company with solid management and a track record is much more capable of surviving downturns in the market. Also, find out how many shares the company's director holds (should be at least 50%) and whether he is increasing his stake in the company.

 

• Past Price Appreciation: The best performers have a history of outperformance and a track record of growth. This momentum can continue for several years to come.

 

 

 

 

6. Is Small-Cap Investing For You?

 

Compared to large-caps, small-cap investing involves greater risks and higher return potential. Understanding your risk tolerance and time horizon is essential before investing.

 

Small-cap investments are better suited for younger investors who plan to hold stocks for decades than retirees living off dividend income.

 

Given that the small-cap sector comprises many underreported stocks, you must have the time, skill, and interest to analyze them before directly investing.

 

Inexperienced investors who need more market knowledge can opt for small-cap managed funds, where professional managers manage the money. It is advantageous as you don't need to make investment decisions and benefit from the expertise of full-time professional managers.

 

Note that though finance professionals run the funds, it doesn't remove the risks inherent in the sector. Moreover, you need to pay fund management fees to receive the service.

 

Lastly, trading small caps can cause a wide range of emotions within you, such as joy, anger, regret, euphoria, despair, stress, and confusion. How you control your emotions determines your winning or losing in a trade.

 

Small-cap investing can be worth considering if you are good at managing emotions and have a rigorous trading plan.

 

 

7. How Much Do Small-Cap Stocks Return On Average?

 

Hundreds of small-cap stocks on the ASX spread across several industries, and business cycles exist. Performance assessment is one of the significant factors to consider when picking the right small-cap stock.

 

The MSCI Australia Small Cap Index measures the performance of the small-cap sector of the Australian market. The index has delivered a 10-year yearly return of 9.70%. (Past performance does not guarantee future results.)

 

Always seek the help of a professional financial advisor before making any investment decision. Investing carries risk.

 

 

 

8. Can You Buy Small-Cap ETFs in Australia?

 

Yes. These are two small-cap ETFs in Australia:

 

 

The Vanguard MSCI Australian Small Companies Index ETF (ASX: VSO)

 

• The fund tracks the MSCI Australian Shares Small Cap Index

• The management fee is 0.30% per year. 

• Investors get distributions from the fund once in six months.

• It held 164 securities on October 31. 

 

 

 

The Betashares Australian Ex-20 Portfolio Diversifier ETF (ASX: EX20)

 

• The fund provides exposure to approx. 180 ASX-listed stocks ranked in market capitalisation from 21 to 200. 

 

 

Always seek the help of a professional financial advisor before making any investment decision. Investing carries risk. The above are just some general options for educational purposes. All these options come with risk. This is not financial advice.

 

 

9. What is The Vanguard Small Cap ETF?

 

As of December 16, 2022, the Vanguard Small Cap Index fund has assets worth $42.70 billion spread across 1,498 different holdings.

 

This medium-sized ETF with $44,471,437,867.20 AUM is for investors looking to maximize exposure to small-cap U.S. companies.

 

Furthermore, its net expense ratio of 0.05% makes it attractive to many.

 

 

10. Tips For Trading Small Caps

 

Trading a stock requires effort and time, especially if it is a small-cap.

 

Here are a few tips to make your small-cap adventure more financially rewarding:

 

• Deeply study the fundamentals and financials of the small caps before you invest.

• Place 'limit orders' if the trading volumes are low.

• The current stock price isn't necessarily the price you have to pay to buy shares. It shows the price at which the last transaction occurred. Always use the 'real-time quote window' to check the immediate bid and the asking price. It clarifies how much you should pay to buy a stock.

• Stay patient. Refrain from acting on every news or price movement. If you have done the research, and have faith in that stock, then don't rush. 

• Refrain from investing in bulk. Build your positions over days or weeks. It will give you a better opportunity of getting smaller trading orders filled right away.

• Ensure you regularly review and evaluate your trading plan.

 

 

 

11. Frequently Asked Questions (FAQs)

 

 

Is It Better To Invest in Small-Cap Stocks?

 

Whether small-cap stocks are a good investment depends on your investing goals and financial situation.

 

They have the potential to deliver outsised returns. However, higher potential rewards come with a higher level of risk.

 

Compared to mid-cap and large-cap stocks, small-cap companies have limited financial resources to operate and grow. It makes them more susceptible to failure.

 

Furthermore, small-cap shares have less liquidity than larger-cap stocks, implying it may take longer to sell them at a price reflecting their value.

 

Nevertheless, adding them to a well-diversified portfolio can help boost your investment returns due to their high potential for outperformance. However, remember that this is not guaranteed, as it depends on your selected stocks. Some may be winners, and others may be losers.

 

 

Who Should Invest in Small-Cap Stocks?

 

Investing in small-cap is not for everyone, especially new investors who may get swayed by the higher returns.

 

Only investors with a long-term investment horizon should consider investing in small caps as it will enable them to ride through the high volatility in these stocks over the short term. Quality stocks have always given good returns over the long run, so you can expect the same with this type of stock.

 

You should only invest in small caps if you don’t need your invested capital for at least 5 to 6 years. In the short to mid-term, you may see negative returns on your investments, which could make you exit the position.

 

Moreover, as small caps are small, they tend to fluctuate sharply, leading to an abrupt rise and fall in stock prices. So, only those investors who can control their emotions amid drastic stock price movements and continue holding their positions can consider investing in them.

 

Large-cap or low-risk debt mutual funds are better than small-cap stocks if you are a beginner or a short-term investor.

 

 

How Long Should You Invest in Small-Cap Stocks?

 

Historically, small-caps have performed well and given good returns on investment in the longer term. In the short run, they are very volatile. So, if you choose to invest in these stocks, stay invested for a minimum of 5-6 years.

 

(Past performance does not guarantee future results.)

 

 

 

How Much of My Portfolio Should Be in Small-Cap Stocks?

 

How much you should invest in small-cap stocks mostly depends on how much risk you are willing to take.

 

A conservative investor could invest 60% in large caps, 30% in mid-caps, and 10% in small caps. (This is only an example)

 

However, if you are an aggressive or growth-oriented investor, consider reducing your large-cap allocation by a small percentage and diverting it towards small-caps.

 

Always seek the help of a professional financial advisor before making any investment decision. Investing carries risk. The above are just some general options for educational purposes. All these options come with risk. This is not financial advice.

 

 

What is The Average Return in 10 Years for Small-Cap Stocks?

 

Australia has a broad range of small-cap stocks operating in various essential sectors such as healthcare, technology, mining, energy, agriculture, and the milk industry.

 

When looking at the ASX 200, large-cap stocks have given an average 11% yearly return over the past ten years. On the other hand, small caps have generated 16.5% annual returns over the past ten years, which is excellent!

 

This has caused more and more investors considering large caps for investment to switch to small caps to benefit from their higher potential for long-term returns.

 

(Past performance does not guarantee future results.)

 

 

Is It Worth Investing in Small-Cap Funds?

 

Small-cap companies are younger companies that may have significant growth prospects than their larger peers.

 

Where a large-cap stock can become larger, a small-cap stock has the potential to be the large-cap stock of the future. Due to the enormous price rise potential, it is much easier for a small cap to grow 20 to 30% than a blue chip to grow by 5%.

 

Furthermore, their share price fluctuates more due to small-caps' volatility than larger ones. It enhances the possibility of delivering significant stock price appreciation than large caps.

 

Capital gains are another advantage of small-cap investing. Small-cap shares that transition to large-cap shares can deliver higher returns in the long run.

 

Additionally, you earn income with dividends often paid half yearly at a much higher rate than any bank interest rate.

 

Moreover, their low price offers cheap diversification to investors to help them manage their investment risks.

 

(Past performance does not guarantee future results.)

 

 

 

Do Small Caps Outperform Over Time?

 

Traditionally, it is thought that small-cap stocks give the best returns and outperform large-cap stocks due to their rapid growth. As investors take high risks in backing more volatile smaller companies, they are rewarded for small-cap investing.

 

When Looking at the long-term returns, the small-cap index has underperformed the large-cap index by approx. 2.8% p.a. (since 1990) with 25% higher risk. It doesn’t mean that no profit-making opportunities exist in small caps.

 

Recognising the optimal moments to invest in small-cap stocks and consistently handling the process of moving in and out of the small-cap market is the key factor that can lead to making profits.

 

Always seek the help of a professional financial advisor before making any investment decision. Investing carries risk. The above are just some general options for educational purposes. All these options come with risk. This is not financial advice.

 

 

Do Small-Cap Funds Give High Returns?

 

Yes and No. Australian small caps have a generally positive track record as small-cap companies are often young and hungry.

 

They could grow aggressively and have great potential but may not be easily identifiable to most investors.

 

However, only investors with the skills and strategy to find small caps with the most growth potential early succeed with small-cap investing.

 

Find a smaller company with a good market for its services and products, as a larger market implies more opportunities for revenue generation.

 

Mining, energy, technology, and resources are the main growth drivers within the small-cap area. Investing in small caps in these sectors could set you up to reap the rewards. (no guarantee)

 

 

 

Why Not Invest in Small-Cap Stocks?

 

Small caps are undoubtedly rewarding but risky if you select stocks incorrectly. Getting swayed by their high returns without researching their business, fundamentals, and technical can lead to losses.

 

Here are a few drawbacks of small caps that make them unappealing for some investors:

 

• Volatility: Compared to large caps, the share price of small caps can fluctuate to a larger extent in upturns and downturns of the market.

 

• Risk: Most smaller companies have less robust balance sheets and access to the same lending as large companies. It makes them a risky investment. Small caps are more vulnerable to market crashes, recessions, and other shocks, making them more likely to be unprofitable.

 

• Liquidity: Due to fewer small-cap shares listed on the market, they are relatively harder to buy and sell on the exchange. Also, based on the company's industry, it could be more vulnerable to a dip during an economic slowdown.

 

 

Do You Need Small Caps in Your Portfolio?

 

If growing wealth is your primary objective in investing or trading, you could add small caps to your portfolio.

 

They are a great inclusion to your portfolio for their outstanding ability to deliver higher returns in the long term with a limited capital outlay. However, they come with a higher risk than already well-established companies and higher returns are not guaranteed.

 

Available at low prices, small caps let you achieve diversification without a lot of money to start. It helps reduce your risk by not putting all your investments in one stock.

 

Though they have tremendous growth potential, having a long investment window of at least 5 to 6 years is the best to mitigate market risks.

 

 

 

Do Small Caps Do Well in Inflation?

 

Small caps offer both risks and advantages over large caps during inflation.

 

These smaller companies may have difficulty absorbing higher expenses than their larger peers. Also, being more labour-intensive than large ones, the rising labour costs during inflation could put small-cap profits at risk.

 

On the contrary, owning small caps has also been beneficial during inflationary periods. They are the only primary asset class that has performed relatively well and beaten inflation each decade since the 1930s.

 

Small-cap firms occupying key positions in the value chain have power over suppliers and customers during these times. It enables them to deliver more stable and higher margins than other businesses.

 

However, to ensure potential small-cap success amid inflation, you must find those within the growth sectors like energy, consumer staples, pharmaceuticals, natural gas shipping, etc., along with considering their market/product fit, valuation, and profit scalability.

 

 

 

Why Do Small-Cap Stocks Outperform?

 

• Small caps are usually a startup or young company that can grow exponentially and become a large cap, as they have room to grow. Unlike mature companies that see slowing revenue growth, it is easier for small caps to double their revenue due to higher growth rates. Amazon and Netflix, now some of the biggest companies in the world, once traded in the small-cap range. If you had bought and held them when they were small, your initial investment would have appreciated over 100 times.

 

• As these stocks have high beta and fewer investors follow small-cap stocks, they often have bigger swings on news like earnings reports.

 

• Small-cap companies are much smaller than their larger-cap peers and have greater growth potential. Their higher volatility causes them to outperform during young bull markets when stocks move faster. (Past performance does not guarantee future results.)

 

• Smaller companies benefit from monetary policies, such as low-interest rates and fiscal stimulus programs, that enable them to borrow, grow, or sustain their businesses during tough times. 

 

 

How Do Beginners With Little Money in Australia Invest in Stocks?

 

Here are a few cost-effective options for beginners to invest in the stock market:

 

• Create a trading account with an online discount broker. Once your account is active, you can buy stocks on the platform yourself. You will incur lesser brokerage fees. Find a broker that lets you purchase fractional shares instead of a full share.

• Market tracking ETFs is another affordable way for beginning traders to enter the stock market. It charges the lowest fee of all other ETF options, such as actively managed ETFs and Thematics. Also, market-tracking ETFs are ideal for new entrants as they don’t need to research individual companies. The ETF provider will buy stocks of companies (on the index) for them and re-weight them quarterly.

• Micro investing is also gaining popularity among newer investors looking to start stock investment in Australia. Setting up smaller weekly deposits with some providers lets you get cash back on your shopping. 

• On signing up, the micro-investing app will invest in the predetermined index or ETF funds that suit your risk tolerance. 

 

 

11. Conclusion

 

Investing in small-cap shares can yield substantial returns but, at the same time, increases the risk of losing your capital, as these are higher-risk stocks.
 

Including the best-performing stocks in a diversified portfolio can enhance overall returns. However, assessing your financial situation and objectives is crucial, and establishing personal investment goals before making any decisions.

 

If you still need a share trading account, consider eToro, which is used by many investors in Australia and worldwide. You can create an eToro trading account HERE.

 

eToro Service ARSN 637 489 466 promoted by eToro AUS Capital Limited ACN 612 791 803 AFSL 491139. Capital at risk. See PDS and TMD.

 

 

 

 

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