In this article
- How small-cap stocks can help you diversify
- Some pros and cons
- Investment strategies
- Understanding small-cap stock funds
One of the most interesting theories to emerge from stock market research is that which describes the so-called small-firm effect. Its premise is that stocks of smaller companies tend to outperform stocks of larger companies. However, while small-cap stocks have historically earned higher returns than other types of investments, they also carry a higher risk of market fluctuations.* Therefore, they may be appropriate for investors with a long investment time frame who hold a well-diversified portfolio.
Small-Cap Stocks Defined
"Cap" refers to the market capitalization of the company issuing stock. The company's total market capitalization includes the value of stock and debt outstanding. Although definitions of what constitutes "small" cap can differ, a commonly used benchmark for small-cap funds, the S&P SmallCap 600 Index, includes companies with capitalizations less than $1.4 billion.
Many smaller companies serve niche markets with steady consumer demand for their products and services, or emerging industries with the potential for substantial future growth. Such companies may experience above-average earnings growth or have earnings that are less susceptible to changes in the overall economy. On the other hand, the smaller capitalizations of these companies can make it harder for them to sustain a business downturn. Also, they tend to have more bank debt relative to total capital than do larger firms, so profits of some smaller companies may be sensitive to rising interest rates.
Small-Cap Stocks: Some Pros And Cons
Although large-cap stocks were generally the top performers in the late 1990s, historically, small-cap stocks have outperformed the overall market, and have outperformed since 2003.* Over time the difference has been dramatic. For the 50-year period ended December 31, 2012, $1.00 invested in large-cap stocks would have grown to $106; the same investment in small-cap stocks would have grown to $357.** This past performance does not guarantee future results.
Small companies typically do not pay dividends. They also are more thinly traded than stocks of larger companies. These factors tend to make small-cap stocks more volatile than large-company stocks. While the purchase or sale of 10,000 shares would have little effect on the price of a blue chip stock, it could have a major impact on a smaller company with a similar share price.
*For the 10-year period ended December 31, 2012. Source: Standard & Poor's. Large-cap stocks are represented by Standard & Poor's Composite Index of 500 stocks, an unmanaged index considered representative of the U.S. large-cap stock market. Small-cap stocks are represented by the S&P SmallCap 600 Index, an unmanaged index. Past performance cannot guarantee future results. Individuals cannot invest directly in any index.
**For the 50-year period ended December 31, 2012. Sources: Center for Research in Securities Prices, University of Chicago 1963-1993; Standard & Poor's, 1963-2012. Large-cap stocks are represented by Standard & Poor's Composite Index of 500 stocks, an unmanaged index considered representative of the U.S. large-cap stock market. Small-cap stocks are represented by the Center for Research in Securities Prices 6th-10th Decile of New York Stock Exchange from 1963 to 1993 and the S&P SmallCap 600 Index from 1994 to 2012, unmanaged indexes. Past performance cannot guarantee future results. Individuals cannot invest directly in any index.
|Average 12-Month Rates of Return
|Sources: Standard & Poor's; Morgan Stanley; Barclays Capital. Based on the 12-month rolling returns in the 10-year period ended December 31, 2012. Large caps are represented by the total returns of the S&P 500. Midcaps are represented by the S&P MidCap 400 Index. Small caps are represented by the total returns of the S&P SmallCap 600. Foreign stocks are represented by the total returns of the MSCI EAFE Index. Bonds are represented by the total returns of the Barclays U.S. Aggregate Index. Cash is represented by the total returns of the Barclays 3-Month Treasury Bellwethers Index. Investors cannot invest in an index.
Based on total returns 2003-2012. Returns do not reflect the effects of commissions and fees.
Different investments offer different levels of potential return and market risk. International investors are subject to higher taxation and currency risk, as well as less liquidity, compared with domestic investors. Small-cap and midcap stocks are generally subject to greater price fluctuations than large-cap stocks. Bond investments are subject to interest rate risk so that when interest rates rise, the prices of bonds can decrease and the investor can lose principal value. Unlike stocks and corporate bonds, government T-bills are guaranteed as to principal and interest if held to maturity, although funds that invest in them are not. Past performance does not guarantee future results.
The Small-Cap Premium Potential
In the 1970s and early 1980s small-cap stocks outperformed large-cap stocks on a risk-adjusted basis.* This excess return has been termed "the small-cap premium," an extra return earned by small-stock investors.
A theory for the excess returns small-cap stocks earned in these years is known as "the neglected-firm effect." If General Motors announced a merger, it would be front-page business news around the world, but the day-to-day activities of small businesses often go unnoticed. Another explanation is that institutional stock analysts, people who track investments for the major investment banks, mutual funds, and pension plans, are primarily focused on larger companies.
*Sources: Standard & Poor's; the Federal Reserve; 1970-1983. Risk is adjusted by comparing the ratios of returns in excess of a risk-free rate with standard deviation of returns. Large-cap stocks are represented by Standard & Poor's Composite Index of 500 stocks, an unmanaged index considered representative of the U.S. large-cap stock market. Small-cap stocks are represented by the Center for Research in Securities Prices 6th-10th Decile of New York Stock Exchange, an unmanaged index. The risk-free rate is represented by the yields on 3-month Treasury bills, published by the Federal Reserve. Past performance cannot guarantee future results. Individuals cannot invest directly in any index.
Small-Cap Stocks And Diversified Portfolios
Small-cap stock returns tend not to move in lockstep with stocks of larger companies. Instead, small-cap performance has tended to lead or lag that of larger companies for periods of several years. Given such potential cyclical differences, small-cap stocks have offered investors an opportunity to help manage the overall risk of a portfolio of large-company stocks by including a small-cap component.
This combined with higher return potential is a primary reason suitable long-term investors may want to consider investing a portion of their portfolios in small-cap stocks.
Small-Cap Investment Strategies
Investing in individual small-cap stocks can be difficult for the individual investor. Small-cap stock picking is often more difficult due to a lack of readily available company-specific information. Higher transaction costs and higher risks associated with small-cap stocks are additional barriers. Investors can help manage liquidity risk by looking for stocks with a weekly trading volume of at least 60,000 shares. Companies that you know and that have a competitive record of steady profits and financial strength may be less risky.
Small-Cap Stock Funds
Some so-called small-cap funds also invest in stocks of larger companies. One reason is that once a small-cap fund grows beyond a certain size, it begins to run out of companies to invest in, as the universe of small-cap stocks is relatively tiny when compared with the size of the market. Also, the recent bull markets have added to the size of many so-called small firms. For instance, the average market cap of companies in the S&P SmallCap 600 Index escalated from $250 million in 1994 to $917 million in 2012, according to Standard & Poor's. Lastly, since mutual funds are limited in the percentage of a company's shares they can own, and since not all small-cap stocks are considered attractive investments, it doesn't take long before a large mutual fund is saturated in its small-cap exposure. So don't be surprised to find some mid-cap and large-cap stocks in your small-cap fund.
Mutual funds offer diversification and professional analysis and management as an alternative to picking individual stocks. Index funds strive to mirror the returns of a benchmark such as the S&P SmallCap 600. Other small-cap funds attempt to pick individual stocks within that universe to enhance fund performance. In either case, you should realize that benchmark indexes like the S&P SmallCap 600 are unmanaged and they do not reflect transaction costs.
Points To Remember
- Small-cap stocks can help diversify portfolios.
- They also carry a higher risk of price fluctuations.
- While definitions vary, small-cap stocks are generally considered to be those with capitalizations less than $1 billion.
- Small-cap stocks do not move in lockstep with the overall market. Investors can increase the diversification of their portfolio and potentially help manage risk by including small-cap stocks.
- Some small-cap mutual funds may also be invested in large-cap stocks because of limited investment options as a fund grows in size.
Mutual funds provide a means for the individual investor to more easily invest in small-cap stocks.
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