Small Stocks Hold Big Potential

Small-company stocks are having a lousy 2014. So far this year, the group, as measured by the Russell 2000 index, is roughly flat, and it trails Standard & Poor’s 500-stock index, which measures large-cap stocks, by a whopping nine percentage points.

As longtime readers of my column know, I like lousy. Investing styles and categories fall in and out of favor, and the time to pounce is when they are out. Small-capitalization stocks are especially attractive now because they are unloved and because history shows that over the long term, little companies beat big ones. Since 1926, small caps have returned on average two percentage points per year more than large caps. In fact, if you’re a believer in buy-and-hold investing, you can make a good case for owning only small-cap stocks.

Bigger risks. Yes, there’s a trade-off. Over the past 10 years, the Russell 2000 has been 34% more volatile than the S&P 500. That should come as no surprise: In investing, you get paid to assume risk. But if you have the faith and courage to hang on for the long haul, the ups and downs shouldn’t bother you.

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A major advantage of small caps is that relatively few professionals pay attention to them. Why is that an advantage? The “efficient market hypothesis” holds that a stock’s price reflects all publicly available information and that precise future price movements are unknowable. So it stands to reason that stocks that undergo less scrutiny are priced less efficiently than those that are widely followed. Because small companies are less widely followed than big ones, you are more likely to find bargains among them.

Consider a small cap you have probably never heard of: Seacor Holdings, a company that services the offshore oil-and-gas industry. Seacor is one of the top holdings of T. Rowe Price Small-Cap Stock (OTCFX), a superb small-cap fund that is closed to new investors. According to Thomson Reuters, precisely two analysts follow Seacor, a firm with a market cap of $1.6 billion. By contrast, 33 analysts track Halliburton, an energy-services company with a market cap of $57.4 billion.

Prices of companies such as Halliburton, Apple and Google reflect vast amounts of information gleaned by dozens of analysts and deeply involved institutional investors. By contrast, many small caps fly under the radar screen.

Of course, this lack of visibility also means that unexpected news about a small-cap stock can cause a spike (up or down) in its share price. In addition, when mutual funds and other large investors buy or sell many shares at once, it can cause volatility in a stock with a small market cap. But these apparent drawbacks have little effect on returns for long-term holders.

Small caps tend to go in and out of fashion. They beat large caps in the 1960s, the late ’70s and the first half of the ’90s, and they have had a great run since 2000. Has the latest run ended? There’s no way to know for sure, but some analysts are attributing this year’s sluggishness to profit-taking—the rationale they typically ascribe to price movements they can’t otherwise explain.

Another concern is a gnawing fear that interest rates will rise once the economy gets back to a robust rate of growth. Higher rates tend to hurt smaller companies, which lack the creditworthiness of larger ones.

But trying to guess the advent and demise of cycles is a fool’s errand. The wise investor understands that small caps are strictly long-term investments with a high likelihood of beating large caps and the U.S. market as a whole.

The next question is, which small caps? Although there’s no standard definition, small caps are generally characterized as companies with market values of less than $5 billion. That’s a bit big for my taste. The roughly 2,000 stocks that make up the portfolio of iShares Russell 2000 (IWM), an exchange-traded fund that tracks its namesake index, have an average cap of $1.5 billion. The average market value of the 336 stocks that make up the T. Rowe Price fund is $2.0 billion.

The smaller the market cap, the higher the potential return—and the greater a stock’s volatility. I’m fond of mutual funds that specialize in the smallest of the small-cap universe: micro-cap stocks, with the sweet spot being an average market cap of about $500 million. Such funds are hard to find. When they get popular, they tend to attract a flood of assets and often respond by closing to new investors.

An excellent fund that’s still open is AMG Managers Essex Small/Micro Cap Growth (MBRSX). The average market cap of its holdings is $566 million. Over the past 10 years, the fund outpaced the S&P 500 by an average of 1.1 percentage points per year (all returns are through September 5). A big drawback, though, is the fund’s annual expense ratio of 1.50%.

Another fine choice: Bridgeway Ultra-Small Company Market (BRSIX), with stocks that boast an average market cap of just $228 million. The fund returned 50.9% in 2013. It has gained 0.8% so far in 2014, and it’s running slightly behind the S&P 500 over the past 10 years. Still, it has an expense ratio of just 0.75%, and I like it for the next two or three decades.

Among the best funds that tilt toward larger (though not large) companies is Hodges Small Cap (HDPSX). Including 2014, it has been in the top 10% of its category (funds that invest in small companies with a blend of growth and value attributes) for six straight years. The average market cap of its holdings is $2.0 billion.

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Then there’s Baron Small Cap (BSCFX), which has an average market cap of $3.4 billion and an admirably low turnover ratio of just 20% (meaning that the fund holds a stock for about five years, on average). Over the past 10 years, Baron Small Cap, a member of the Kiplinger 25, beat the S&P 500 by an average of 1.7 percentage points per year.

Finally, consider the most popular of all small-cap mutual funds, Vanguard Small Cap Index (NAESX). The fund tracks the CRSP U.S. Small Cap index, which excludes the very smallest small caps. It charges a mere 0.24% in expenses.

It’s fashionable these days to criticize funds whose stocks are chosen by living human beings rather than index algorithms. But because small caps are inefficient, smart research and analysis can pay off.

Should you do your own stock picking? Certainly, if you have the time and some expertise. But for most of us, when the going gets tough, it’s easier to muster the discipline to hold on to stocks when we own them through a mutual fund. Good choices abound.

James K. Glassman is a visiting fellow at the American Enterprise Institute. He owns none of the stocks mentioned.