CHICAGO, April 27 (Reuters) – Ugly duckling stocks are
surprises in small packages that turn into great performing
swans later on down the road. Nearly every large company started
out as a “small cap,” which generally refers to a stock with
under $1 billion in market capitalization. Most small companies
do unsexy things such as make pumps or generic drugs. You’ll
rarely hear them touted by big-name analysts or firms.
When business and economic cycles favor them, though, small
caps soar relative to big-cap stocks, especially because they
are usually priced at a bargain. Over the past three years
through April 25, for example, the Vanguard S&P 500 Fund
rose 19.4 percent. In contrast, the DFA US Small Cap
Value fund climbed 22.7 percent ().
Note: The DFA fund, representing an index of small companies,
is only available through investment advisers.
Long-term, exhibiting what investment analysts call “the
small company effect,” these pint-sized stocks produced a
compound annual growth rate of almost 12 percent from 1925
through 2011, according to Ibbotson Associates’ 2012 Classic
Yearbook (). That compares to
about 10 percent for the S&P 500 index of large stocks,
typically over $2 billion, and about 6 percent for long-term
government bonds. Small caps are generally stocks from $300
million to $2 billion in market capitalization; mid-caps from $2
billion to $10 billion; and large caps from $10 billion on up.
Much of the small-company/value effect has been documented by
academics Kenneth French, Eugene Fama and Rolf Banz
().
Small-cap companies are rarely in the spotlight. Companies
like Lifepoint Hospitals, Westlake Chemical and
Esterline Technologies, for example, are unlikely to
steal the headlines from Exxon-Mobil and AT&T.
Do small caps always outperform large caps? No, there are
periods of time when small caps waddle along and fall on their
face – witness 2008 – but they eventually pick themselves up
again and prove their mettle. Most recently, when euro zone
anxieties jolted the market again on April 23, the S&P Small Cap
Index fell 1.6 percent in a day, compared to 0.8 percent for the
S&P 500.
Overall, small caps tend to be more volatile and pay fewer
dividends than their big brothers, so buying individual issues
always entails much more risk. Younger companies are also often
struggling to become consistently profitable.
The best way to hold small caps is through index funds,
which hold hundreds of them at low cost. Consider the Guggenheim
S&P SmallCap Pure Value ETF, which attempts to replicate
the S&P SmallCap 600 Pure Value Index. Another consideration is
the relatively new Bridgeway Omni Small-Cap Value Fund
, which follows the Russell 2000 Value Index. Want more
exposure to small-cap companies overseas? Look at the iShares
MSCI Emerging Markets Small Cap Index, which focuses on
small companies in developing countries.
When adding a small-cap fund to your portfolio, it’s best to
hold it for at least a decade, preferably longer. They should
never dominate your portfolio if you can’t afford to take much
market risk. That means if you’re retiring soon or need money
for a short-term goal such as a home down payment, don’t put
your money in a small-cap.
My wife and I, for example, are long-term investors, and we
have small-cap value funds in our core individual retirement
account portfolio. We won’t need the money for at least two
decades, so we don’t trade these funds, we just let them grow.
They are not a part of our daughters’ college-savings funds,
which we’ll begin to tap within a few years.
Small caps may get you where you need to be over time, but
they may run in a number of different directions over short
periods of time. So be mindful that swiftness and smallness are
not the same thing as safety.