3 Reasons to Own Small Cap Stocks in 2015

Investing Daily Article of the Week

by Chad Fraser, Investing Daily

Will small cap stocks outpace their large cap cousins this year?

If the first quarter is any indication, conditions look favorable: over the first three-and-a-half months of 2015, the small cap benchmark Russell 2000 Index has notched a 5.0% gain, compared to 1.8% for the S&P 500.

That comes after the S&P 500 more than tripled the Russell 2000’s gain in 2014, marking the widest margin between the two indexes since 1998, according to the Financial Post.

So can small caps’ run last?

The environment for smaller companies certainly looks promising, according to Jim Pearce, chief strategist at our Personal Finance advisory, and Jim Fink, who helms our small- and mid-cap-focused Roadrunner Stocks service.

In the latest issue of Personal Finance, Pearce offers three reasons why this could be a good year to go fishing for small fry:

• Small caps are less affected by a strong dollar: Most large cap stocks rely to some extent on overseas business, and the strong dollar lowers the value of their international sales when they’re converted into greenbacks. At the same time, the high dollar makes their goods more expensive for foreign buyers. This is less of a problem for small caps, which tend to have more of a domestic focus. Meantime, smaller companies benefit as the strong dollar lowers the cost of goods they import.
• Small caps outperform when rates rise: “If you’re concerned about the Federal Reserve raising interest rates later this year, then add small cap stocks to your portfolio,” writes Pearce. “During periods of rising long-term rates and rising short-term rates, small cap stocks outperformed large caps.” Fink outlined two reasons why in a March 19 Roadrunner Stocks article: “Rising interest rates are not a problem for small caps,” he wrote: “Small cap stocks actually outperform large cap stocks in a rising-rate environment because small caps don’t have much debt and are very sensitive to stronger economic growth (which is correlated with rising interest rates). For this and other reasons, it’s a good time to go small.”
• There’s a Democrat in the White House: There are all sorts of factoids floating around about correlations between stock market performance and various political alignments in Washington, like this one: when the president is a Democrat and Republicans control both houses of Congress (as in the current situation), the S&P 500 has gained an average of 15.1% a year between 1901 and 2014-the most of any potential arrangement. Similarly, small caps tend to shine when the White House’s occupant is a Democrat: research from 1927 to 2013 shows that small caps outperform large caps by nearly five percentage points in years when this is the case.

In any case, small caps’ outperformance is far from a short-term phenomenon: they boast a history of outpacing their large cap cousins that stretches back 89 years.

We’ll take a closer look at that track record below. But first, here’s a quick primer on what exactly a small cap stock is and what sets them apart from bigger companies.

What’s a Small Cap Stock?

Strictly defined, small cap stocks are companies with relatively small market capitalizations (or the total value of all of their outstanding shares).

The line between small caps, mid-caps and large caps has shifted over time and varies depending on whom you ask, but today’s small caps generally boast market caps of $250 million to $2 billion. Companies below $250 million are commonly referred to as “micro-caps,” while the smallest of the bunch (less than $50 million) are considered “nano-caps.”

A commonly used benchmark for small caps is the Russell 2000. This index includes the smallest 2,000 companies in the Russell 3000, which comprises the 3,000 largest U.S. companies, or about 98% of the investable U.S. equity market. The Russell 2000 represents about 10% of the larger index’s market cap.

Since the market low of March 2009, the Russell 2000 has gained 260%, compared to a 185% rise for the S&P 500 and 145% for the Dow Jones Industrial Average.

Going back to 1926, small caps outperformed their large cap cousins by 2.38% on an average annual basis up to the end of 2013, according to numbers from Deutsche Asset & Wealth Management.

One reason for this outperformance is that analyst coverage of small caps tends to be scant, leading to investor neglect and undervaluation. But when the mainstream investors catch on, share prices can take off in a hurry.

Another reason is the law of large numbers: it’s far easier for a small company to grow at 50% to 100% a year than a large one; if a company with a $100-billion-plus market cap kept growing at that rate, it would quickly become larger than the economy itself.

Holding small cap stocks also increases the odds of your company being taken over at a premium, as small caps are more likely to be in acquirers’ sights.

Your chances of that happening are better these days, with global M&A activity off to a hot start this year, ringing in at $902.2 billion in Q1, according to Dealogic. That’s up 23.3% from the first quarter of 2014 and the highest quarterly total in eight years. Q1’s buying spree comes on the heels of the busiest M&A year since before the Great Recession.

But even with small caps’ potential, there are a number of things to keep in mind when investing in them. For one, they’re typically more volatile than their larger counterparts, partly because they’re more thinly traded.

Small caps can also fall faster than large caps in a declining market and are more prone to economic shocks, because they lack the economies of scale large caps enjoy, and they have a less-diversified geographic footprint and customer base.

What to Look For

Fink looks at a number of criteria when selecting small caps, including strong management-preferably led by the company’s founder.

Founder-run stocks he likes include auto-dimming car-mirror specialist Gentex Corp. (NasdaqGS: GNTX), which we examined in last Wednesday’s Stocks to Watch article.

Another is Copart, Inc. (NasdaqGS: CPRT), which helps insurance companies sell (mainly damaged) cars through its auction-style websites to vehicle dismantlers, rebuilders and used car dealers.

The company’s chairman, Willis Johnson, led it through its transformation from the auto salvage outfit he founded in 1982 to the online marketplace it is today. The stock is technically a mid-cap, with a market cap of $4.8 billion.

Other earmarks to watch for? High insider ownership, for one (“Because we want management to be partners with us on a stock,” Fink says. “It’s a key Buffett rule.”). He also zeroes in on a company’s operating margins, because unlike earnings, operating margins can’t be manipulated.

Finally, he recommends keeping an eye out for small caps with unique products and services. That gives them a strong competitive advantage because customers can’t get what they sell anywhere else. Without competition, a company has almost unlimited pricing power.

4 Small Caps Buffett Would Love

Warren Buffett and Peter Lynch built their fortunes on swift-moving small cap stocks.

But here’s the problem: they’re literally too rich to profit from them today.

Think about it for a moment: even if Buffett bought every share of a $100-million company and the stock price doubled, it would increase Berkshire Hathaway’s value by just 0.04%. It’s just not worth the trouble!

That’s where investors like you and I have an advantage.