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.