Small-cap stocks are profitable, but risky

Some investors think that small-capitalization stocks are the quickest route to riches. After all, big successful companies like Microsoft Corp. and Thomson Reuters started out as small-cap stocks.

Small_Cap_StocksSmall-caps include all stocks with market capitalizations below some arbitrary amount. But that’s where the similarities end. After all, the total value of the shares outstanding is only one measure of a company, and a crude one at that.

Some small-cap stocks are small but debt-free, such as Key stock Richelieu Hardware. Others have lots of debt—so they’re much bigger, measured by capital employed in the business, than their market caps suggest. Some are small but fast-growing companies. Others are former big companies whose fortunes and market caps have been waning for years or even decades. Some dominate their own tiny industries. Others are innovative newcomers.

You need to own at least one huge success

Academic studies suggest that small-cap stocks outperform large-cap stocks. But most of this outperformance occurred in the years from 1975 through 1983, according to Jeremy Siegel, professor of finance at The Wharton School of the University of Pennsylvania and author of Stocks for the Long Run. Had you missed this period of outperformance by small-cap stocks, you would have fared no better than you would have with large-cap stocks from 1926 through 1974 and 1984 through 2006.

Remember, too, that this statistical advantage is partly due to the impact of a few huge gainers among small-caps rather than widespread strength.

A few huge gainers are apt to turn up in any big group of stocks. But you can’t assume the next Microsoft will find its way into your portfolio. Otherwise, there would be more billionaires. Besides, the winners may owe their huge gains to the fact that nobody knew about them when they were cheap. Or, they have been cheap at their lows due to serious drawbacks they managed to overcome against all odds.

Buy a small-cap stocks index fund

We suspect, too, that if you ranked all small-cap stocks by performance over many years, and eliminated the top 10 per cent and the bottom 10 per cent, the middle 80 per cent wouldn’t do as well as the overall market. That’s because that middle 80 per cent would include all sorts of poorly-performing stocks that never go anywhere in boom times, and that are especially vulnerable in recessions.

With this in mind, we think you need to put extra care into choosing small-cap stocks. For investors willing to run risks for potentially large gains, we do recommend small-cap stocks from time to time.

The best way to make sure you own huge winners is to buy an index fund of small-cap stocks.

This is an edited version of an article that was originally published for subscribers in the July 13, 2018, 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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