Getting Started With Small Cap Stocks

12/31/2014 By Chad Fraser

Strictly defined, small cap stocks are companies with relatively small market capitalizations (or the total value of all of their outstanding shares).

The line between small caps, mid-caps and large caps has shifted over time and varies depending on whom you ask, but today’s small caps generally boast market caps of $250 million to $2 billion. Companies below $250 million are commonly referred to as micro-caps, while the smallest of the bunch (less than $50 million) are considered nano-caps.

No matter where you draw the line, small caps offer a tantalizing benefit to investors: the prospect of higher returns than large caps.

Or as legendary Fidelity mutual fund manager Peter Lynch put it: Big companies have small moves, small companies have big moves.

A commonly used benchmark for small caps is the Russell 2000. This index reflects the performance of the smallest 2,000 companies in the Russell 3000, which consists of the 3,000 biggest U.S. companies, or roughly 98% of the investable U.S. equity market. The Russell 2000 comprises about 10% of the larger index’s market cap.

Small caps have lagged their large cap cousins this year, though they have ended 2014 on a stronger note, with the Russell 2000 outperforming the S&P 500 in the last three months.

And small cap investors are often rewarded for their patience: since the market low of March 2009, the Russell 2000 has gained 253%, compared to a 207% rise for the S&P 500 and a 175% gain for the Dow.

Over the very long term—all the way back to 1926—small caps outperformed their large cap cousins by 2.38% on an average annual basis up to the end of 2013, according to numbers from Deutsche Asset & Wealth Management.

Risks and Rewards of Small Cap Investing

There are a number of reasons why small caps can produce bigger gains than large caps. Here are four:

• Small caps tend to be under-followed by Wall Street, which leads to investor neglect and undervaluation. When the investment community finally catches on, stock prices can move up in a hurry.

It doesn’t pay for Wall Street analysts to cover stocks unless they can generate enough revenue (read commissions or future investment banking fees) to make the time and effort involved worthwhile, wrote Joel Greenblatt of Gotham Capital in his 1997 book, You Can Be a Stock Market Genius.

Therefore, smaller capitalization stocks whose shares don’t trade in large volumes, obscure securities and unique situations are generally ignored. Ironically, the very areas that are uneconomic for large firms to explore are precisely the ones that hold the most potential profit for you.

Even so, there are a number of things investors need to keep in mind when investing in small cap stocks. For one, they typically experience higher volatility than their larger counterparts, partly because they’re more thinly traded.

Small caps can also fall faster than large caps in a declining market and are more prone to economic shocks, because they lack the economies of scale that large caps enjoy, and they have a less-diversified geographic footprint and customer base.

Dividends are also rare in the small cap universe, as companies prefer to plow their profits back into the business to fuel their growth.

What to Look For

To reduce risk and zero in on potential small cap winners, Fink recommends that investors focus on investment quality, looking for things like low debt, rising earnings, persistent free cash flows and revenue growth.

Here are some other factors he likes to see before recommending a stock:

• Impressive management: The greatest idea or breakthrough product means nothing unless you’ve got smart, dedicated people running the show—preferably the founder, he says. I’ve made more money investing in firms with sharp managers and so-so products than in companies with great products and mediocre management.

• Strong operating margins: Unlike earnings, operating margins can’t be manipulated, says Fink. That’s why he considers them a good measure of a company’s true profitability.

• High insider ownership: I want management to be partners with us on a stock, Fink says. It’s a key Buffett rule: owner-operators want the stock to go up as much as you do.

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