Here’s Why Smaller Is Better

While the media spend all their time obsessing over the biggest companies in the stock market, small-cap stocks are quietly producing superior long-term returns.

From 1926 through the end of 2017, small caps beat large caps by nearly 2 percentage points annually.

That may not sound like much, but when compounded over such a long period, it adds up to a huge difference in total return.

But you don’t have to go back that far to see such a big gain.

Since the beginning of 2000, the small-cap Russell 2000 Index has generated a total return of 280.2%, or nearly 118 percentage points more than the S&P 500.

Although small caps can become growth engines, earnings power alone can’t explain their outperformance.

Nor can their sharply higher price volatility.

Instead, some academics attribute their strong returns to two factors: scarcity of information and lack of liquidity. 

Scarce Info

Despite the hordes of analysts on Wall Street, their ranks start to dwindle toward the bottom of the capitalization spectrum.

This creates an informational vacuum that forces investors to do their own sleuthing when analyzing a small-cap stock’s prospects.

It also means that some of the most promising names can trade at a steep discount to their potential value, a pricing inefficiency that skillful investors can exploit. 

But it’s not easy.

Because many small caps are still at an early stage in their growth cycle, their financials can look downright ugly, with many posting ongoing losses.

So it requires no small degree of both diligence and intuition to see the better possibilities ahead for a young, growing company.

Limited Liquidity 

Beyond that, the small-cap space is tiny—its total market cap is just 8% of the total stock market.

And many of its stocks are thinly traded, with some having trading volumes of just a few thousand shares per day.

While part of that is the result of their relative obscurity, it’s also because corporate insiders often hold a substantial number of shares outstanding.

This can limit a stock’s float, or number of shares available for trading by outside investors. And that can make it difficult for investors to buy and sell shares without causing significant price movements. 

However, research has shown that some of the most illiquid stocks generate the best long-term returns.

Part of the explanation likely has to do with the liquidity premium. Investors are willing to pay more for stocks that are easier to trade, so illiquid stocks offer a better relative value.

That brings us to the other part of the explanation: Once others finally catch on to a rapidly growing name, the gains can be explosive, as new investors overwhelm a small stock’s usual trading volume. 

Stick with the Pros

While aggressive investors may find it tempting to abandon larger companies for small caps’ higher returns, there are numerous hurdles to successfully navigating this space.

And though small caps soundly beat the market over the long term, there are periods when smaller stocks lagged large caps, such as during much of the 1990s.

Still, smaller companies tend to have lower correlations to the broad market, and can therefore zig when the market zags.

That may account for part of their outperformance since 2000, a period marked by two major downturns.

So it makes sense to maintain a small allocation to such stocks. Depending on individual risk tolerance, small caps should probably comprise no more than 20% of an investor’s overall equity allocation. 

But this is one area where even self-directed investors are better off delegating to the professionals.

That’s where services like Investing Daily’s Radical Wealth Alliance can help.

The new service looks for small-cap stocks with explosive growth potential. And it just unveiled five new picks that are flying under the radar.