Cheap, Small and Dominating the Market

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Fellow Small Cap Investor,

The fact that some companies are smaller than others doesn't necessarily mean they're less attractive to investors. Often small-cap companies offer better returns than large-cap companies - and we just might be in one of these markets today.

That's because small cap stocks tend to outperform coming out of recessions as growth in these nimble operations increases at a greater rate than their larger competitors. While small-cap stocks do tend to have greater volatility (beta) historical returns show that they have done extremely well relative to the rest of the market over the long haul.

According to financial research firm Ibbotson Associates (now part of Morningstar), small-cap stocks have outperformed large-cap stocks over the last 80 years. In a 2005 study, the firm divided the entire stock market into 4 broad categories- small-cap value, large-cap value, small-cap growth, and large-cap growth.

After tallying the results it turns out that if you had invested $1 in large-cap growth stocks in 1927, your investment would have been worth $884 in 2005. That's a great investment, right?

Well, not exactly.

That $884 dollars is pocket change, compared to the $45,144 you would have made if you had invested in small-cap value stocks. This is compounding returns at its absolute best. To some, the difference in annual returns might look insignificant. But over 75 years, the effect of compounding returns and outperformance meant that the same dollar that returned 884% in large-cap value returned over 45,000 percent when invested in small-cap value stocks.

The compounded annual return from 1927 to 2005 was 14.7 percent for small-cap value stocks versus 11.9 percent for large-cap value stocks.

***What factors could have led to such dramatic outperformance by small-cap value stocks? It turns out there are several, and the most important ones are at work right now.

In a low interest rate environment, like the one we are in now, smaller companies have better access to growth enabling capital - and they can generate superior returns on that capital. Given that the U.S. economy is still weak the Fed is not showing any signs of raising rates in the near future.

Second, as the dollar strengthens, large-cap companies are impacted more than small-cap companies. The reason comes down to international sales. A strong currency represents strong domestic growth relative to other economies. When the dollar appreciates, small-cap companies' growth tends to outpace that of larger firms because small firms tend to get a larger percentage of sales domestically. As the dollar strengthens foreign customers have less purchasing power, and they tend to buy fewer goods from those companies, mainly large caps, in the U.S.

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I should mention that in the five year chart above there was an aberration in the correlation of small cap stocks (as measured by the S&P 600 above) and the U.S. Dollar - during the latest financial crisis investors fled to the dollar as a safe-haven asset. The popularity of the dollar during this time led to a spike in the dollar - even thought small cap stocks remained at depressed levels. But once the economy began to recover, the dollar and small-cap stocks resumed moving in the same direction.

Small-cap stocks do better than large firms when there's a strong dollar because generally large-cap companies have more international exposure. If the dollar is strong or is strengthening, keep an eye on small-caps.

***These are just two market conditions to look for when considering weighting your portfolio toward small-cap companies. And right now we have a strengthening dollar, and low interest rates.

I won't guarantee small-caps will outperform every time these favorable market conditions exist, but I wouldn't be doing my job if I didn't alert you to the huge profit potential.

This is similar to what has happened in the past. Small-cap companies tend to do well at the beginning of the business cycle when economic activity gains momentum.

According to Fidelity Investments, coming out of the last 8 bear markets, small-cap stocks have outperformed the S&P 500 by an average of almost 14 percent in the first 24 months after the equity market bottoms out.

It's only been 18 months since the market bounced off those lows in March of last year.

Are there another 6 months of small cap outperformance on the way? Only time will tell. But if the dollar stays strong, interest rates remain low, and the economy continues to recover, those of us with exposure to small-cap companies will most likely be rewarded.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

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