Small-caps include huge winners

But devote only a small part of your portfolio to small-cap stocks. It’s impossible to keep track of a 1,000-stock portfolio.

It stands to reason that huge winners—stocks that go up by 50-to-one or 100-to-one—generally start off from a small base. Some investors take this to mean that you should have most of your money in so-called ‘small cap’ stocks. These are stocks with a market capitalization below some arbitrary figure, such as $150 million. (Market capitalization or ‘market cap’ is the figure you get when you multiply a company’s share price by the number of shares outstanding.)

A few huge winners raise the average

Studies show that small-cap stocks beat big-cap stocks. In fact, from 1926 to 2012, the smallest 10 per cent of US stocks produced an average compound yearly return of 17.03 per cent. The comparable figure for the largest 10 per cent of US stocks was 9.28 per cent. But this was thanks to strong returns in the nine years from 1975 through 1983. The above-average gains of small-cap stocks also reflect the occasional 50-to-one or 100-to-one payoff, rather than consistent or widespread strength.

We think small caps should make up only a modest part of your portfolio. One thing we’ve often noted is that small caps vary widely in their performance—as you’d expect. After all, there’s no sameness among stocks with market caps below $150 million. Some are small but debt-free. Others have lots of debt—so they’re much bigger, measured by capital employed in the business, than their market cap description suggests. Some are small but fast-growing firms. Others are former big companies whose fortunes and market cap have fallen for years. An example is General Electric.

Rare and hard to spot

Some small caps are prominent or even dominant in their own tiny or newly-formed industries, and these are always worth a look. Often it’s the creator of a new industry, rather than a new company taking the lead in an old industry, that brings the 50-to-one or 100-to-one payoff. An example is US stock Microsoft Corp. in its early years. Of course, stocks like these are rare and hard to spot, and they don’t stay small-cap for long.

There is a common disadvantage to all stock-picking systems that rely on the statistical advantage of a particular class of stocks—small-cap stocks, low price-to-earnings ratio stocks, new issues or whatever. Even when they work, they only narrow down the list of possibilities, from tens of thousands to a thousand or two. No individual (and few mutual funds) can keep track of a 1,000-stock portfolio.

When you try to winnow down the 1,000 for your own portfolio, you may wind up excluding the handful of big winners that you need to make the system work. After all, the big winners often owe their huge gains to the fact that nobody knew about them or recognized their appeal when they were cheap. These firms, for example, may have faced serious obstacles that they later overcame, against all odds.

Small-cap stocks include a handful of enormous winners, and a far larger crop of losers. With hard work and some luck, you may stumble on one or more of the big winners. That’s what portfolio manager Peter Lynch did with Walmart. But pick haphazardly and you’ll wind up losing money. Remember virtually all scams are small caps. In fact, some of today’s shabbiest promotions trumpet the fact that they were small caps, because the promoters have discovered that the words appeal to investors.

Our advice is to focus on value rather than market cap when you choose investments. But in any event, devote only a small part of your portfolio to small-cap stocks. It’s impossible to keep track of a 1,000-stock portfolio.

This is an edited version of an article that was originally published for subscribers in the March 25, 2022, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.

The Investment Reporter, MPL Communications Inc.
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