"Are small caps a smart asset class to invest in right now?"
That's the question I set out to answer for more than 100
investors at our Wall Street Daily conference in Chicago on
Tuesday. I figured our broader audience (i.e. - you) would be
interested in my analysis, too. Especially since many pundits keep
issuing warnings about small caps in the current market.
Earlier this week, for instance, MSN Money ran a column
entitled, "Looking for Growth? Small Caps May Not Be the Answer."
And a few weeks before that Reuters ran an article entitled, "Why
the Small-Cap Rally May Stall."
I disagree completely with such a viewpoint. And here are three
Contrarian Reason #1: The Past Matters
Over long periods of time, small caps flat out return more than
Multiple studies on data going back to 1925 confirm it, too.
From Ibbotson Associates, Bernstein Research, Fama and French, and
more recently, Royce Funds.
The outperformance ranges from 2% to 5% per year. Compounded
over time, that's significant.
As Richard Bernstein concludes, "Small stocks offered the best
risk/reward potential to investors." Period!
Of course, naysayers are bound to quip that we can't simply
focus on really long-term performance. After all, it represents the
average annual returns and therefore, masks periods of
Fair enough. But that's still not a reason to write-off small
Contrarian Reason #2: Performance Endurance
Over shorter periods of time, it's true that small caps don't
always outperform large caps.
However, it's important to note that small-cap rallies endure…
In every decade since the 1930s, Royce Funds found that small
caps enjoyed prolonged periods of prosperity and outperformance.
Periods lasting six years long with an average return of 273%.
(click to enlarge)
Against such a backdrop, the current rally for small caps hardly
qualifies as long in the tooth. Since the market bottomed
three-and-a-half years ago, the Russell 2000 Index is up only
Again, naysayers are bound to complain we're looking too far
back and we should, instead, focus on most recent history. So,
let's do that then…
Contrarian Reason #3: Don't Buck the Trend
Since the market hit rock bottom in March 2009, small caps have
outperformed large caps by a full 30 percentage points. Most
recently, small caps have been leading the way, too.
Since August 1, the Russell 2000 Index is up 8.4%, nearly
doubling the return of the S&P 500 Index over the same
Put simply, the trend is our friend. And it's unlikely to
reverse course in the near term, either.
I say that simply because earnings expectations keep plummeting
into negative territory for S&P 500 companies (i.e. - large
caps). The culprit? Exposure to weak European markets. However,
small caps lack significant exposure to overseas markets.
Accordingly, third-quarter profit forecasts remain firmly positive
for small caps.
Thomson Reuters estimates a year-over-year profit decline of
2.1% for S&P 500 companies. But for companies in the Russell
2000 Index, third-quarter earnings are expected to increase
And since stock prices ultimately follow earnings, it's only
natural to expect that small caps will keep outperforming their
Bottom line: At this stage in the bull market, I'll concede it's
unwise to expect every last small cap to rally. That doesn't mean
we should write-off small caps completely, though. It just means we
need to be selective.
Instead of blindly buying into thousands of small caps via an
exchange-traded fund like the
iShares Russell 2000 ETF
), I'd focus on investing in individual small-cap value stocks.
With that in mind, I'll be sure to provide you with some specific
opportunities to consider in the coming weeks. So stay tuned.
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