The bulk of the benefits for small-cap stock investors come from buying the tiniest of the tiny. By James K. Glassman, Contributing Columnist May 28, 2010 One of the rules of investing -- not to mention other aspects of life -- is that the riskier the bet, the higher the payoff. Bonds issued by shaky Greece pay higher interest rates than U.S. Treasuries do. Bet $10 on a single number at roulette, and the profit if you win is $350; lay down $10 on red, with odds that are roughly even, and you make just $10 for being right.In the stock market, risk is typically measured by volatility -- or how much returns bounce around. So it's natural to assume that if a particular group of stocks is more volatile than the market as a whole, then that group should return more than the market. In fact, that's precisely the case with small-capitalization stocks, which for the purposes of this column I will define as those with a market value (number of shares outstanding times the stock price) of $1.5 billion or less. Surprisingly, it wasn't until 1981 that academia documented the propensity of riskier small caps to outperform the overall market. Since then, the author of the seminal work, Rolf Banz, has been challenged by other economists and analysts, who argue that the so-called small-firm effect is not really so powerful and may simply be a transitory phenomenon. I disagree. The overall figures provide compelling support for the argument that, over the long haul, the smaller the companies, the greater the returns, on average. According to the latest Morningstar data, the largest of the large caps (those in the first decile, or top 10%, by size of all companies listed on the three major U.S. exchanges) returned 9.1% annualized from 1926 through 2009. The smallest of the small caps (stocks in the tenth decile, by size) gained an annualized 13.1% -- nearly half again as much. Advertisement Smooth progression. More remarkable, returns for the deciles in between rise steadily, and near perfectly, as the companies get smaller. So stocks in the third decile (with market caps between $3.4 billion and $5.9 billion) returned 10.7% annualized, on average, while stocks in the eighth decile ($431 million to $685 million) returned 11.4%. Also, in keeping with what we would expect, risk rises consistently as market caps decline. Make no mistake: Stocks of the smallest companies are really volatile. The standard deviation of stocks in the tenth decile is a whopping 45%. That means that two-thirds of the time, the range of annual returns for these stocks is between 58% and -32%. By comparison, the range of annual returns for the largest companies has been between 29% and -10% two-thirds of the time. To see the extent of the volatility, you need to look at only two recent years. In 2008, first-decile stocks lost 35%; in 2009, they gained 23%. In those same years, tenth-decile stocks lost 47% and then gained 81%. Since 1926, the worst single-year performance ever for first-decile stocks was in 1931, when they were down 41%. But tenth-decile stocks (the smallest of the small) have lost 47% or more five times. Individual stocks vividly demonstrate the contrast. In 2008, mega cap Procter & Gamble lost 14%; in 2009, it gained 1%. In those same two years, Johnson & Johnson, another blue-chip behemoth, lost 8% and gained 11%. In other words, they gave investors smooth rides even in rough seas. But see what happens when you pick a few stocks at random from a solid micro-cap fund -- say, Royce Micro-Cap Trust (symbol RMT), a closed-end fund run by a shop with a long and generally successful record of investing in small companies. Richardson Electronics (RELL), a maker of electron tubes that is roughly one-one-thousandth the size of J&J, lost 57% in 2008 and gained 103% in 2009. In those same two years, Hardinge (HDNG), a machine-tool manufacturer, sank 75%, then recovered 37%. Advertisement Some stocks win, some lose, but history shows that small caps return more than big caps. So the question you need to ask before taking the plunge is this: Am I willing to endure a gut-wrenching ride in order to win a bigger prize at the destination? Your answer should be yes, as long as you keep tiny caps to a limited piece of your total portfolio -- say, 10% at most. The small-firm effect. These outsize returns seem to have two sources. The first is simply that little companies have more opportunity to grow. You can't expect ExxonMobil (XOM), with a market cap of $307 billion, to quadruple in value in just a few years (its market value would soon exceed the gross domestic product of Russia). But if you choose well, you can score a ten-bagger with a company that has a market cap of $100 million (and if you choose poorly, you can lose all of your money). The second source of the small-firm effect is probably more important. James O'Shaughnessy, in the 2005 edition of his book, What Works on Wall Street, wrote that small caps outperform "not because of market capitalization alone but because the stocks in this category are least efficiently priced." About 350 stocks account for three-fourths of total U.S. market capitalization, while many thousands of stocks comprise the remaining quarter. The ninth and tenth deciles together (with market caps under about $400 million, a good definition of micro caps) account for less than 2% of total market capitalization. Analysts and journalists pay little attention to these companies, so their prices reflect relatively paltry knowledge about the workings of the underlying companies. O'Shaughnessy says the bulk of the benefits for small-cap stock investors come from buying the tiniest of the tiny. He found, for instance, that between 1952 and 2003, returns for stocks with market caps of $100 million to $250 million averaged 16.4% annualized; returns for those with market values between $500 million and $1 billion averaged 13.9%; for those greater than $1 billion, 13.1%. Advertisement So you've got to go low to really cash in on the small-company effect. But that's not easy. The inefficiencies of micro caps make them harder for you to analyze, too. And if you buy or sell a significant number of shares of a thinly traded micro cap, you're bound to affect the share price adversely. Demand can bump up the buying price, and you may have a hard time finding a purchaser when you want to sell. How to invest. Most investors will find it more productive to buy micro caps in bunches. But here, too, there's trouble. Few money managers have strong offerings, and many of the top mutual funds are closed to new investors. The best of the open no-load micro-cap funds is Aegis Value (AVALX), which gained an annualized 11% over the past ten years, compared with a small loss for Standard & Poor's 500-stock index, which tracks large-company stocks. Unlike many funds that have "micro cap" in their names but own scads of larger companies, Aegis is the real thing; its holdings have an average market value of just $220 million. They include Bassett Furniture (BSET), with a market capitalization of just $66 million, and Books-A-Million (BAMM), with a market value of $111 million. Another micro-cap fund to consider is Bridgeway Ultra-Small Company Market (BRSIX), with an average cap of $168 million and a ten-year return of 9.4% annualized. Its top holdings include Arrow Financial (AROW), a small chain of banks in upstate New York, and Atrion (ATRI), a medical-devices firm that I have recommended several times in my annual picks. The Bridgeway fund carries an expense ratio of only 0.75%, precisely half that of Aegis. Advertisement It's difficult for me to recommend any other open-end micro-cap funds right now. Wasatch Micro Cap (WMICX) has a decent ten-year return, but its expense ratio is an unacceptable 2.24%, and it holds too many large companies. In fact, the average market value of its holdings is $606 million. An interesting alternative among actively managed funds is the closed-end Royce Micro-Cap Trust. At its May 7 close of about $8 per share, the fund sold for a 16% discount to the value of its underlying assets. You can invest in micro caps with exchange-traded funds. But the performance of ETFs such as iShares Russell Microcap Index (IWC) and PowerShares Zacks Micro Cap (PZI) has been unimpressive -- perhaps because the micro-cap universe is full of flameouts as well as stars ready to soar. You need a human to tell the difference. James K. Glassman is executive director of the George W. Bush Institute in Dallas. His next investing book, The Comeback, will be published later this year by Crown.