Investing Strategies: Small-Cap Investing

When it comes to beating the market, Steve Martin had it right with the title of his first album: Let's Get Small. However, since that album is long on "Excuuuuse me!" and short on historical asset returns, let's turn to the esteemed Stocks, Bonds, Bills, and Inflation Yearbook, published every year by Ibbotson Associates, for real investment advice.

Image source: Getty Images.

From 1926 to 2006, small-cap stocks beat large-cap stocks by an average annual 2.3 percentage points. That may not knock your arrow-through-the-head off, but consider that $10,000 invested for 30 years and earning 10.4% annually (the long-term return of the S&P 500 over that period) would grow to $194,568. Not bad. However, at the 12.7% compound average annual return of small-cap stocks, that $10,000 would grow to $361,175 after three decades. Definitely not bad.

You might be asking, "What exactly is a small-cap stock?" You'll hear plenty of definitions -- a company worth less than $2 billion, for example -- but there's no clear, bright line between small-cap and large-cap stocks. The thousands of publicly traded companies fall along a broad spectrum of size and historical returns.

To illustrate, instead of dividing the market into just two sizes (small and large), let's break it up into 10 groups, or "deciles." The table at the left displays the returns and standard deviations (a measure of volatility) from 1926 to 2006 for stocks in each decile, with the first decile representing shares in the largest 10% of companies, and the 10th decile representing the smallest 10%.

Source: Ibbotson Associates.

As you can see, risk (as measured by standard deviation) and stock size have historically been inversely related: Smaller companies experience higher ups and deeper downs. The same goes for return and stock size. But why do small caps outperform? Let us count the ways.

The small advantage
1. Scant coverage. Small caps fly under the radar simply because Wall Street is dominated by institutional investors with boatloads of money; they can't invest in smaller companies without driving up the price. Also, most mutual funds are prohibited from investing more than 5% of their money in a single company, or owning more than 10% of a company's outstanding stock. Thus, funds with billions in cash can't invest much in a company worth -- say, $500 million, tops.

2. Smaller companies can grow more quickly. The biggest companies produce revenue of $100 billion and more. It takes a long time for such behemoths to double sales of that magnitude, especially since they tend to be slow growers.

In contrast, you'll often find small companies that are growing sales at a much faster clip. Because they have such a small sales base to start out with, they can sustain stronger growth for a lot longer than their large-cap counterparts.

3. Small-cap stocks are riskier. Any finance textbook will tell you that risk and return are related, at least in a general, long-term way. Smaller companies are often startups with an unproven business, less-experienced executives, and limited access to capital. This makes their prospects less certain than those of blue-chip companies that everyone has confidence in and knows well.

However, we must emphasize that "long-term" aspect of risk and return. Small caps can underperform large caps for long periods. From 1984 to 1999, the big boys beat the pipsqueaks by about five percentage points a year. After outperforming large caps during most of the 2000s, small caps weren't the screaming values they had been. However, timing the market is impossible, so devote a portion of your long-term (i.e., 10 years or more) portfolio to small caps.

Key metrics

1. Size: How small do you want to get? In the 2007 edition of the Ibbotson yearbook, the largest company in the smallest decile had a market cap of just $314 million. That's petty cash compared to the big boys.

Compare that to $1.2 billion, the mean market cap of all companies in small-cap funds covered by Morningstar. That cap size falls in Ibbotson's seventh decile, which tends to have better returns than the S&P 500, but less of the extra volatility micro caps endure. For most investors, that's an acceptable trade-off.

And then there are really small small caps -- companies worth far less than $1 billion. To invest in these, beginners should look to mutual funds, where diversification helps dampen the increased risk. If you can stomach declines of 50% and hold for many years, consider so-called micro-cap funds that invest in tiny companies.

2. Inside ownership: Companies run by people with plenty of skin in the game have extra incentive to see the stock flourish. To view who owns how much of a stock, visit Yahoo! Finance, enter a ticker, and click on "Major Holders."

3. Value vs. growth: Which has the best long-term results? Ask Ibbotson (keepers of the longest long-term data), Morningstar (which conducted a study on which funds have beaten the stock market from 1992 to 2007), or Eugene Fama and Kenneth French (two pioneering professors who've sliced and diced the market more than any other academics). They'll all say the same thing: Value beats growth. Especially in the small-cap arena.

Of the 20 best-performing small-cap funds from 1992 to 2007, seven were classified by Morningstar as value funds (including the top three); 10 were blend (a mix of value and growth); and only three were growth. There are fine small-cap growth funds out there, but for best results, keep most of your money in value and core small-cap funds.

The bottom line? Small-cap stocks boast high potential. Although beginning investors looking to dip their toes in smaller waters may feel more comfortable with funds, you can look to put together your own portfolio of stocks as you gain experience.