Investing in small-cap companies can be considered a risky proposition, but it can also be a very rewarding one; the key for investors is to identify quality small caps that have the potential to become tomorrow's top performing companies, according to Callum Burns, managing director & portfolio manager at ICE Investors.

Mr Burns says not all small caps are created equal and there is a significant performance dispersion between small companies. Many either fail to thrive or underperform. However, focusing on high-quality small companies with strong competitive advantages can yield significant long-term value for shareholders.

"The small-cap universe can be a significant challenge. There are a lot of opportunities out there, but there are also many pitfalls. This is why a careful, methodical approach to stock selection is extremely important in small cap investing. There are around 200 companies in the ASX Small Cap Index, and many more not even in the index, yet many of these companies are not attractive from an investment point of view,” he said.

According to research conducted by the ICE Investors team, the “sweet spot” of small cap investing can be found within a high-performing subset – the potential future top 100 companies —those companies with robust business franchises.

"Companies with strong competitive advantages are more likely to succeed in the long run. They are also more likely to be quality companies that can weather future economic storms," he said.

Mr Burns said that one of the most important things to look for in a small-cap company is a strong competitive advantage. This could be anything from a unique product or service to a brand or unique infrastructure.

“Robust business franchises are characterised by several key features including having an economic moat around the business that protects revenue from competitors; difficult to replicate assets, such as licenses and brands; barriers to entry for new competitors; an entrenched customer base that faces obstacles in switching to competitors; sustainable competitive advantage and pricing power.

“With a focus on firms with strong business franchises, investors can tap into the potential for substantial outperformance and avoid lower quality companies that may lead to underperformance and ultimately, poor returns over the longer term.

“By undertaking comprehensive research and proper due diligence, investors will be better equipped to identify tomorrow’s top 100 companies,” he said.

Despite the potential of small caps for long-term growth, the S&P/ASX Small Ordinaries Index has shown significant underperformance of the S&P/ASX 100 index since early 2022, as highlighted in the chart below. According to Mr Burns, this dislocation in performance remains in place today, however the ICE Investors team believes this is only a temporary dislocation and that investing in small companies with strong business franchises can yield dramatically different outcomes over time as illustrated by the team’s research into the sector.

“This is demonstrated by looking at data over the last 20 years which shows that small companies with strong business franchises consistently deliver superior returns compared to the broader small-cap universe and the overall share market,” he said.

As the above chart highlights, the small cap businesses with solid franchises represented by the blue line provide superior risk-adjusted returns due to their robust business models and consistent earnings growth. In contrast, lower-quality small caps, represented by the lavender line, generally exhibit weaker prospects and less durable growth.

“There are still many great small-cap companies out there waiting to be discovered. However, investors need to be equipped with the right research and due diligence to differentiate between low-quality small caps, with little potential to outperform, from the next top 100 companies.

“Our investment approach at ICE Investors, helps us to differentiate and identify the next top 100 in the small caps space by finding strong business franchises with a solid competitive advantage and strong prospects to outperform in the long term,” said Mr Burns.