Small-cap stocks are riskier, as the companies have less operating history, says Jennifer Law of CIBC Asset Management. She's the manager of the Renaissance Canadian Small-Cap Fund.
But, they also offer higher growth rates. And the market is backed by strong stock performance and returns.
"To offset taking on more risk, [tell clients] they get better long-term performance," says Law. "If you look back, small caps—including dividends—have outperformed large caps by more than 30% over the last 45 years. You get compensated for taking on more risk."
However, "If you look at any capital markets, the majority of research, about 95%, is directed towards the large-cap names."
She says banks are well covered, with investors receiving almost all of the information needed to make informed decisions. The same level of coverage and scrutiny doesn't exist for small caps.
And this is a problem, as the small-cap opportunities on the TSX alone are numerous. There are over 3,000 companies listed on the exchange, and most research is done on the top 300 names.
With the remainder, she says, "This is where we can do some valuable, fundamental work in terms of finding them, following them, tracking management performance, and finding how much the companies are worth."
That lets investors choose names and sectors that aren't traditionally covered, giving them an edge over the broader market.
Law's team looks at business efficiencies, growth rates and capital needs, and they work with management in term of what the business plan is over the next two-to-three years. They also ask for a current business valuation.
"[With] small caps, the trick is to look at a lot of the companies out there," she says. "When you spot a good management team and a good business plan, you need to understand the business and the industry. You also need to come up with a good method to evaluate the company by several different valuation metrics."
These can include intrinsic value models and net-asset value models. Figure out what the company is worth with detailed analysis to mitigate the downside risks of investing in small-cap companies.