Motley Fool: The higher returns you want can mean bigger risks to take

Nobody would put up with the higher risks of small caps unless they held out the hope of higher returns, as any academic would tell you.

So if you want a shot at the higher returns that small caps have delivered in the past, more risk comes with the territory. But here’s a thing, many Foolish investors might argue about the relevance of some of the risks to their own portfolios.

For instance, do you really care about short-term price volatility, if you’ve got a long-term, business-focused mindset? And other apparent downside might be even turned to a smart investor’s advantage.

I’m not suggesting investing alchemy here. We can’t turn risks into rewards – we can only accept risk in the pursuit of higher rewards. But here are five commonly agreed upon risks that you might actively aim to exploit.

1 Small caps are less well researched

If you’re a big fund manager running billions of pounds, you lean heavily on analysts when making your investments.

Why wouldn’t you? Those billions don’t invest themselves, and there are only so many hours in the day. Analysts have time to dig deep into the particular companies they follow.

However, small companies are not of interest to most big fund managers because they typically can’t (or won’t) own enough of them to make a difference to their portfolios.

If they own 5 per cent of a £100m small cap in a portfolio of £1bn, its share price would have to double for their overall returns to budge by 1 per cent!

Of course, if they owned £5m worth then more modest gains would make a difference, but for all kinds of reasons that might not be an option with a small company.

Hence, most City money and its finest brains ignore small caps. This increases your opportunity to find and invest in a good undervalued company before everyone else has noticed.

2 Many small caps are listed on the notorious AIM market

When Obi-Wan Kenobi warned of a “wretched hive of scum and villainy” in Star Wars, he was talking about the space port of Mos Eisley. But to many private investors, he might have meant AIM.

The AIM market has a terrible reputation in some quarters, due to everything from dubious companies and perceived flaws in regulation to a preponderance of smaller resource stocks that have disappointed investors over the years. However, there are also great companies on AIM that have stood the test of time and delivered strong returns. If you can look at AIM companies that others ignore due to blanket revulsion, then you might find a gem. And as a bonus – there’s also no stamp duty to pay.

3 Poor liquidity means prices lurch up and down

When you own small-cap shares, you get used to seeing their prices move by 10 per cent in a week. It’s not uncommon for them to ‘gap’ by, say, 5 per cent in just a few hours.

But often this is just due to poor liquidity. With few buyers and sellers, prices can move erratically – or steadily drift downwards when there’s not much news about.

Yet if you believe in the company’s merits and expect to own it for years, what do you care what the price is at 3pm some Tuesday?

By being willing to put up with their mercurial prices, you can again look at companies that other investors avoid on principle – which again means more chances of a bargain.

You can exploit the price volatility when you buy, too.

4 Wide bid-offer spreads are another bugbear

The bid-offer (or bid-ask) spread is the difference between the price you pay to buy shares, and what you will get if you’re a seller.

For blue chips, this spread may be just a few tenths of a per cent. But I’ve seen small-cap shares with bid-offer spreads of 10 per cent! True, those are the worst cases. But spreads of 3-5 per cent are not unusual.

Such a wide spread immediately destroys value, putting your investment in a hole before you’ve even started. However, if you’ve found a wonderful smaller company that you hope to hold for many years, then a big bid-offer spread is less relevant.

The longer you own the shares, the less the spread matters. After holding for a decade, the cost of a 5 per cent spread has been spread over 10 years, to a fairly trivial amount.

5 Some small cap firms are family affairs

Small-cap share registers are often dominated by insiders, such as founders or ex-managers or members of the current executive team. A quirk of the UK market is that some of these insiders may all belong to the same family!

Many professional investors avoid such companies like the plague.

They feel it’s poor corporate governance at best, which could lead to poorer returns – and at worst it makes inciting remedial action by dissatisfied shareholders very difficult.

However, you and I are not likely to be amassing controlling stakes in our favourite companies any time soon – no more for £60m Dewhurst than for a multinational like BP.

So this perceived disadvantage doesn’t amount to any loss of professional influence or pride for us.