Small Stocks for Big Gains

As we enter the final month of the final year of the decade, investors face the eternal question: how much should I have in stocks at this point? As a start on that answer, we must acknowledge that thinking about stocks as one asset class really is an oversimplification. I suggest we look first at a subset of the stock universe that is generally considered the highest potential return element of an investment portfolio: small stocks.

Small stocks defined

Small stocks in the US are public companies with a market capitalization of $300 million up to around $8 billion. As these small companies get larger, they can be worth as much as $10 billion before they move into the next category. There are several dominant index ETFs that hold small US stocks. The three with the largest capitalizations have anywhere from 600 to 2000 small companies in them. Outside of the dominant providers, there are hundreds if not a few thousand strategies available to invest in small-cap stocks.

Small stocks in the rest of the world

The rules about size and inclusion in the small-cap universe outside of the United States are less uniform and quite a bit more complicated. For instance, many small international stocks pay high dividends because earnings are taxed even if they are not paid out. In addition, a good small stock international fund will have several underlying currencies that can impact performance. When buying small international stocks you get a mixture of influences that you don’t get in the US. We can go into further detail outside of this article.

Small stocks outperform

Small stocks hold an enviable position on the stock spectrum: over decades small stocks perform significantly better than big stocks. Simply put, small stocks have to grow enormously for a long time to become the biggest, worldwide companies. For example, Microsoft, Apple, and Amazon (the top three in the S&P 500) were all classified as small stocks when they had their initial public offerings. Apple closed its first trading day with a $1.7 billion market cap. Microsoft was under $1 billion. Amazon was under $500 million. Each company is now trading at an astonishingly high $1 trillion market value.

Morningstar/Andex produces a well-known chart showing that over the long run small US stocks return two percentage points more per year than large stocks. This advantage, compounded over a generation or longer constitutes a huge margin of outperformance.

Small stocks and volatility

Unquestionably, small stocks are more volatile than big stocks. In aggregate, they tend to dip lower than their large-cap counterparts during times of market distress. They don’t just follow the broad market, either. In recent months, for instance, US small-cap stocks have lagged the performance of the largest US companies.

Small stocks have fewer markets, customers, products and geographic opportunities than big companies. These limitations can make small companies appear more economically precarious. That can spook investors and drive people to sell out when confidence is low.

While short-term fluctuations can repel some investors, higher volatility is a plus for long-term investors as it means more opportunities to buy in at attractive prices. If you can stand above-average volatility in your portfolio then small stocks deserve a significant allocation. If you can tolerate currency risk then small international stocks have a place, too.

Quirks of small stock performance

One quirk is that long term investors can often benefit from market-timed small stock purchases. When the S&P 500 dips, small stocks may temporarily be priced even lower. For long-term investors, buying small stocks on these dips has proven to be quite profitable simply because small stocks tend to go up much more when the S&P 500 rebounds.

Another quirk is the “home bias” of US small stocks. Small US companies have been less impacted by the tariff action of the last three years because they do most of their business in the United States. In many cases, small-cap business is good even though their stock prices are lagging this year.

A third quirk is the high dividend yield of international small stocks. Their yield is over 3%, compared to 1.4% in the US.

Looking ahead

As Max wrote last week in The Big Debt Crisis Article, we are not on the verge of debt-fueled economic trouble. We can expect occasional bubbles and recessions. I don’t see a bubble in small stocks but a brief recession in the next few years may be inevitable. For new purchases, a recession would be a big opportunity to add a significant performance boost to your portfolio through greater small stock purchases. If you would like to see how we balance all the factors described above, please contact us for more information.