Why Invest in Small-Cap Stocks?
Many investors fear the unknown, and thus stick to companies whose names they know and are familiar with.
The problem with this inclination is that these investors end up with a portfolio of “brand name” stocks, most of which are large or very large companies.
What’s the problem with large companies, you might ask? Although it is true that larger company stocks tend to be less volatile, and more stable growers than smaller companies, this translates into lower revenue and earnings growth rates. In a growth stock portfolio, the main driver of share price appreciation is the growth of the company’s sales and EPS.
Typically, large company stocks can sustain annual growth rates of just 6%-8% over time, which is below the overall performance of the stock market, between 9% and 11%.
Even if a portfolio can generate average dividend yields of 1%-3%, it’s very difficult to outperform the market with a portfolio of stocks that is over-weighted with large companies. Large-company stocks simply can’t provide enough “juice” to overcome the risks of investing in the stock market, and they actually serve as a drag on portfolio performance.
Contrast the expected growth of large-company stocks with those of midsize and small-company stocks. Midsized companies generally can support EPS growth rates of 8%-12%, while smaller companies are where real growth can be found, with projected EPS growth greater than 12%.
It’s for this reason that BetterInvesting, the national nonprofit investor education organization, recommends that investors include a mix of large, small, and midsized companies in their portfolios. They suggest that a portfolio that consists of 25% large-company stocks and 25% small-company stocks, with the balance in midsized companies, helps to reduce risk and achieve a higher rate of return than a portfolio burdened with too many large companies.
In this light, it is apparent that an important role that large companies play in a growth stock strategy is to help reduce the risk profile of the holdings. For the reward side of the investing equation, investors must include a healthy percentage of small company stocks.
The Importance of Non-correlation
To fully understand the importance of diversification with respect to company size in a portfolio, the concept of non-correlation must be introduced.
In the context of investing, non-correlation is the tendency of different segments of a market to not move in the same direction at the same time. Historically, large-company stocks and small-company stocks display a significant degree of non-correlation of about 72%. (A correlation of 100% would mean that both categories move exactly the same up or down at the same time.)
When large-company stocks do well, small-company stocks fall behind. On the flip side, when small-company stocks do well, large-company stocks tend to lag.
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For maximum portfolio growth and risk management, a growth stock portfolio must include smaller companies. A portfolio that combines companies of all sizes will have a better chance of beating the market averages over time.
The SmallCap Informer
aims to help identify opportunities for long-term oriented investors to maximize their investing results with sensible ideas for small company stocks.