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Buy Small-Cap Stocks and Profit as they Become Large-Caps

“Big companies have small moves, small companies have big moves.”

— Peter Lynch

When looking for stocks that can score huge price gains in the future, it often is helpful to look back and see what worked in the past.  Just for kicks, I performed a stock screen for the ten stocks in the Russell 3000 Index with the greatest total return over the past 10 years (starting market cap of $100 million or more to insure liquidity).  The numbers are awe-inspiring:

Best Performing Stocks of the Past Decade

Company

10-Year Total Return

Market Cap 10 Years Ago

Business

Netflix, Inc.
(NSDQ: NFLX)

6,030%

$1.7 billion

Video rentals

Trex Company
(NYSE: TREX)
2,830% $128 million Building materials

Align Technology (NSDQ: ALGN)

2,270%

$1.1 billion

Invisalign orthodonture

Cantel Medical (NYSE: CMD)

2,260%

$188 million

Infection prevention devices

MarketAxess Holdings (NSDQ: MKTX)

2,230%

$458 million

Electronic Trading Platform for Fixed Income

Stamps.com (NSDQ: STMP)

2,220%

$241 million

Internet-based mailing services

Abiomed (NSDQ: ABMD)

2,080%

$507 million

Heart pumps

Amazon.com (NSDQ: AMZN)

2,070%

$39.9 billion

Internet Retail

Westlake Chemical (NYSE: WLK)

1,940%

$1.2 billion

Basic chemicals and building materials

Credit Acceptance Corp. (NSDQ: CACC)

1,920%

$625 million

Auto loans and reinsurance

Source: Bloomberg

Looking at the list, the stocks come from a wide range of industries, yet almost all have one thing in common: they started their epic run as “small-cap” companies (i.e., below $2 billion market capitalization). Some, like Cantel Medical and Trex Company, started very small.

Intuitively, this makes sense based on the law of large numbers.  It’s much easier to grow 50%-100% per year when starting from a small base than it is when starting from a large base. Investing in the next Apple (NSDQ: AAPL) is not going to happen by investing in Apple itself. Otherwise, large-cap companies with $100 billion-plus market caps would quickly grow larger than the economy itself!

The Magic Formula

Small-cap value stocks have dramatically outperformed large-cap stocks over the long-term:

Small-Cap is #1

 

Group

 

Compound Annual Return (1926-2016)

 

$1 Invested in 1926 Worth in 2016

Small-Cap Value

12.1%

$33,212

Large-Cap Value

10.0%

$6,035

Source: Ibbotson Associates

A combination of small size and value (e.g., low price-to-earnings) appears to be the magic formula.

It is not a coincidence that Trex Company, the second-best performing stock of the past decade, not only had a tiny market cap in 2008 but also was cheap with a P/E ratio of only 7.0. The P/E ratios of other small stocks in the top ten were similarly low – Westlake Chemical had a P/E of 11.6 and Credit Acceptance had a P/E of only 12.0.  While momentum traders were chasing story stocks trading at P/E ratios of 100 and up, the real future winners were these cheap little guys that nobody was paying attention to (except for Internet freak-of-nature Amazon.com).

Three Risk Factors is Better Than One

In fact, the magic formula of small size and value is at the heart of the Fama-French Three-Factor Model (TFM), which has replaced the single-factor capital asset pricing model (CAPM) as the accepted standard for predicting the risk and expected return of a stock. Long story short, the CAPM assumed that a stock’s risk was completely explained by its relative volatility compared to the general stock market (a.k.a. beta).  In contrast, the TFM adds small size and value metrics as additional risk factors. Academic research has confirmed that the TFM predicts 95% of a stock portfolio’s subsequent return compared to the CAPM’s paltry 70% predictive power. 

Historically, small stocks had been thought to offer higher returns because they were more volatile (i.e., had higher betas than the market):

 Small Caps Are More Volatile

Stock Style

Standard Deviation (1926-2016)

Large-Cap

19.9%

Small-Cap

31.9%

Source: Ibbotson Associates

What TFM found is that small-cap stocks generated a higher return even after adjusting for their higher beta. There is something driving small-stock outperformance other than higher volatility. What is that “something else?”

Does Small = Riskier?

Without question, being of small size and selling for a value price increase returns, but there is considerable debate whether these increased returns are based on increased risk – the efficient market theorists’ position – or are simply the result of market inefficiency. University of Chicago finance professor Eugene Fama, an author of the TFM, is clearly in the increased risk camp. With regard to small stocks, he states:

The 1980s were, supposedly, the longest period of continuous growth the country had seen since the Second World War. Yet, in that decade, small stocks were in a depression. Small stock earnings never recovered from the ’80-’81 recession. They were low the whole decade. Why did that happen in the ’80s? I don’t know. But it happened. And it tells you there is something about small stocks that makes them more risky.

In contrast, Joel Greenblatt of Gotham Capital in his funny-sounding book “You Can Be a Stock Market Genius,” writes that structural inefficiencies in the capital markets cause small-cap stocks to be undervalued and generate above-normal returns:

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. 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.

Value investor Warren Buffett also falls in the inefficiency camp, claiming that individual investors should be able to earn 50% annual returns with small amounts of money because they have access to high-return small-cap stocks that he can no longer buy because of Berkshire’s huge asset size. 

Can’t Both Be Right?

Personally, I think both sides of the debate have merit.  Small-cap stocks are under-followed and ignored by Wall Street, which leads to investor neglect and undervaluation (i.e., inefficiency). However, it is also true that small-cap stocks are more vulnerable to severe economic shocks due to their typically higher debt load, non-existent economies of scale and scope, and their less diversified geographic footprint and customer base.  Small-caps can –- and do — go bankrupt, which sometimes has the nasty effect of turning their seeming undervaluation into no valuation.

One must also recognize the difference between the total small-cap universe and a carefully selected subset. Perhaps, as a whole, small stocks are riskier. But smart analysts like those we have here at Investing Daily (not to mention value investors like Warren Buffett and Joel Greenblatt) can eliminate this added risk by isolating only the best small-cap companies in which to invest.

Finding the Small-Cap Pearl Among Swine

Clearly, not all small-cap stocks go bankrupt in times of economic distress. Among the entire universe of small-cap stocks, some outperform the market during these times.  Wouldn’t it be great if one could isolate those small-cap stocks most likely to outperform and only invest in them?  The degree of outperformance from investing in small-cap stocks would be even higher if you could weed out the likely small-cap losers.

And small-cap losers there are. Professor Joseph Piotroski of Stanford University reports that less than 44 percent of small-cap value stocks outperform the market in the two years following their designation as small-cap value stocks. In other words, the small-cap value stock universe outperforms the market despite the fact that a majority of small-cap value stocks are losers! As Piotroski states:

The success of small-cap value investing relies on the strong performance of a few firms, while tolerating the poor performance of many deteriorating companies.

Let’s face it, some small-cap stocks are cheap for a good reason – their business prospects are in decline and getting worse. Other small-cap stocks are cheap because of investor neglect despite the fact that their financial fundamentals are solid and improving. Piotroski’s thesis is that by screening for small-cap value stocks with improving financial fundamentals, you can avoid small-cap value stocks that face continued financial deterioration and price declines and isolate those small-cap stocks that have begun a turnaround and promise significant price gains.

Slow Down There, Pardner

A few caveats should be kept in mind, however. First, although a mechanical stock screen like Piotroski’s may generate impressive results, it is unable to screen for qualitative factors, such as strong management teams. Second, small-cap stocks are more volatile than the general market and can underperform for long periods of time. 

So, unless your investment time horizon is several years, you should keep small-cap stocks only a moderate portion of your overall equity portfolio. James O’Shaughnessy argues in his 2007 book “The New Rules For Investing Now” that small-cap stocks will significantly outperform over the next 15 years. Yet even he recommends that small-cap stocks be limited to 35% of your equity portfolio.

And whatever you do, don’t be out of the market during January! Literally all of the outperformance attributed to small-cap stocks occurs in January. Between February and December, small-cap stocks have historically slightly underperformed large-caps.

Just the Facts, Ma’am

Let’s sum up:

  1. If you want outsized returns, you must invest in small-cap value stocks.
  2. Nine of the ten top-performing stocks of the past decade were small caps and most were value stocks. I can almost guarantee that the top-performing stocks of the next decade will be small caps as well.
  3. Most small caps underperform, so the key is either finding the few small caps that will produce the 50, 60, and 70-baggers, or instead buying the entire small-cap universe to insure that you won’t miss out on the big winners.
  4. Small caps have above-average volatility and can underperform for long periods, so their outsized returns may require a long timeframe to be realized.
  5. Whether small caps are inherently more risky or just inefficiently priced is undecided, but investment prudence dictates that you normally limit your small cap allocation to less than half (some say 35%) of your total equity portfolio and avoid them altogether during incipient periods of severe economic distress (assuming you can foresee recessions and/or depressions – ha!)
  6. Never be out of small-cap stocks during January.

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