Transforming a £500 pile of cash into £5,000 by investing in shares is quite a challenge. But it’s still possible. One popular approach is to put my capital into an index exchange-traded fund (ETF). These financial products charge very low management fees and match the performance of the market, essentially putting a portfolio on autopilot.
However, here in the UK, the FTSE 100 index has delivered an average annual return of 8.3% (including dividends). Needless to say, that could take quite a while to reach the target of a 1,000% gain. So, is there a faster approach?
The power of small-cap stocks
Small-cap stocks are an interesting segment of the stock market. These firms are typically young, with limited resources, and are often small for a good reason – even more so when venturing into the world of penny stocks. So far, that’s doesn’t sound particularly promising. But for an investor like me willing to take on an increased level of risk, these companies can be some of the most lucrative investment opportunities.
Plenty of high-quality businesses fall under this category, either because they’ve only just started making waves or have been previously mismanaged. And thanks to their low market capitalisations, regulations prevent most financial institutions from investing in shares of these businesses. That means high-quality small-cap stocks can often be undervalued.
More importantly, is the growth capability. It’s far easier for a £50m enterprise to double its value than, say, a £50bn one. After all, the smaller business only needs to generate another £50m of value versus the £50bn required by the latter. Or, as famous investor Jim Slater put it, “elephants don’t gallop”. Investors who spotted the potential of dotDigital early on, know this all too well. Over the last nine years, shares of this small-cap company have risen an incredible 1,260%!
The risks of investing in shares of small-cap stocks
As exciting as the prospect of achieving a 1,000%+ return by investing in shares is, this comes with considerable risk. As I previously stated, these businesses tend to have limited access to external capital compared to a larger firm. If anything goes wrong, and a small-cap company suddenly needs to raise a lot of money, it could have a pretty tough time doing so.
What’s more, a lot of these businesses tend to have small product portfolios and can be dependent on an undersized collection of key customers. Should a product be rendered redundant by a competitor or a key customer decides to leave, these shares can quickly plummet.
Taking a leap of faith
When researching a small-cap stock to invest in, I spend more time focusing on what could go wrong rather than right. And in most cases, the risk is simply too high for my tastes. But every once in a while, a hidden gem emerges like Somero Enterprises.
The engineering group designs and develops automation technology for the construction industry. And with a market capitalisation of only £300m, I believe this company has the potential to generate a quadruple-digit return for my portfolio over the long term.