Special Report: Perfect Allocation: How to Profit from Small Cap Stocks

The greater the risk, the greater the reward.

All too often, this common mantra is left completely unquestioned by Wall Street.

The motto assumes return/risk is a give-and-take scenario, but things don't always play out that way.

The truth is there are several tried and tested strategies shown to increase reward without any increase to risk whatsoever. These are the strategies that reliably separate professional investing from bona fide gambling.

One such strategy involves adding small-cap stocks to your portfolio; allocating a significant portion of your portfolio to small-cap stocks is proven to increase reward while maintaining the same level of risk.

Take this recent data from Morningstar Stock Research as an example. Portfolio C, which contains 30% small-cap stocks, has the same level of risk as Portfolio A, which contains 100% large-cap stocks.

small vs large cap

At the same time, Portfolio C offers a much greater return than Portfolio A: $572,899 versus $327,004 — both on a $10,000 investment over 30 years:

growth in portolio

Proper Allocation

For anyone looking to take control of his or her own investments, allocation across market caps is incredibly important.

Exactly how you allocate is ultimately up to you and will depend on your aversion to risk, but it's more than clear that a significant portion should be dedicated to small caps.

To further illustrate this point, consider that over the last 30 years or so, the small-cap sector has brought investors the greatest return on the dollar by a landslide, and at no point during this period did small caps underperform either mid-cap or large-cap stocks:

small mid and large cap stocks

For every $10,000 invested in large-cap stocks, investors saw an average return of $327,000 over the course of 30 years — not too bad.

But for every $10,000 invested in small caps, investors saw an average return of $885,000 — more than twice the return seen with investments in larger companies.

Small caps don't just perform over the long run, though — the Russell 2000 Index, which was constructed as an unbiased representation of the small-cap equity market, has consistently trended upward over the last five years.

Compared to the Russell 1000, which represents large caps, the Russell 2000 has grown twice as fast, consistent with trends seen between 1975 and 2005.

Why Small Caps?

There are a number of reasons why small caps consistently outperform competing sectors. We'll address some of these reasons below.

1) Agile Figures

This one's pretty simple: it's easier to double figures when the baseline is small. For example, growing revenue from $20 million to $40 million is much more practical than growing $20 billion to $40 billion.

Likewise, the market is more inclined to push a $9 stock to $18 in a short period of time than to move a $400 stock to $800.

2) Nimble Operations

The larger a company becomes, the more difficult it is to manage. Smaller companies often find themselves in growing industries and are able to respond to changing market conditions. Large caps have less success adapting because they become deeply entrenched in a specific role.

At the same time, smaller companies are often run by dedicated founders or a small management team that is dedicated to increasing shareholder value.

3) Inefficient Market

Small-cap stocks are rarely covered by large brokerage firms, which results in the high possibility of inefficient pricing. Likewise, there is limited analyst coverage, so many small firms — and their details — get overlooked.

Generally, these factors reduce the number of buyers for a stock, often causing prices to be unjustifiably low. As these companies grow and perform, the stocks gain more attention, increasing volume and valuation.

4) Hidden Value

Related to the points directly above is the existence of hidden value. Though the roles of small companies are often very obscure, many are well positioned in incredibly niche industries. Despite their size, these companies can be indispensable gears that move a much larger machine.

The more specific a product or service, the lower the chance of competition. Likewise, small caps that service larger firms are often takeover targets, allowing investors to profit from significant premiums on shares.

Keeping Risk in Mind

While allocating a portion of your portfolio to small caps can increase reward without raising overall risk, it's still important to understand that small caps carry a unique form of risk worth considering. Below are a few risks specific to small-cap investing and tips on minimizing them.

1) Low Liquidity

Because small caps are not covered by major firms and go unnoticed by much of the market, shares trade hands less frequently. This means at times, there may not be enough buyers or sellers to fulfill a particular order.

The obvious risk here that you could get caught in a position where you want to liquidate due to unforeseen events but cannot because there aren't enough buyers in the market. For this reason, you should never invest too much in one small-cap stock to ensure your orders can be fulfilled.

An additional risk with low liquidity is increased bid-ask spreads. Fortunately, these spreads are close to negligible (fractions of pennies on the dollar) outside of micro caps and options trading.

2) Limited Capital Access

This one should be obvious, as it's inherent in the name: small cap = small capital. This means limited financial resources and the risk of share dilution. Always keep in mind a company's cash position, debt obligations, and burn rate.

3) Less Information

As we mentioned earlier, analyst coverage on small-cap stocks is extremely limited. While this can ultimately be a benefit for investors putting in their due diligence, it can also create adverse scenarios for those who rely widely on public information.

For this reason, it's important to either do your own in-depth research or make sure you're listening to someone else who has done his own. By knowing more than the next guy, you can turn the environment of limited information to your advantage.

4) Unproven Models

Small companies may lack long operating histories and proven business models. This can result in smaller groups of both dedicated investors and loyal customers. These factors can add to large fluctuations in revenue, as well as share valuation.

As with any form of equity trading, understanding a small cap's business model is crucial to making successful plays. Tuning in during quarterly earnings calls is a must, and it never hurts to reach out to Investor Relations for additional information.

Concluding Remarks

Every investment opportunity carries risk and reward. The trick, of course, is to control the former while expanding the latter.

The history of returns on small-cap stocks shows we can do just that. Small caps have consistently outperformed larger sectors and continue to offer growth opportunities not present anywhere else in the market.

The benefits of small-cap investing include hidden value, inefficient pricing, and nimble financial/operating structures. Most notably, it's the dynamic nature of small caps that makes them so profitable.

At the same time, there are unique risks that need to be addressed. But by understanding these factors, it's possible to control and diminish risk without negatively affecting return.

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