Are Small Caps Less Risky Than You Think?

Here's a thing I like about small companies. In many cases, the people who run them aren't just executives -- they're proprietors who took massive risks to build what exists today and who run themselves ragged to make sure that what does exist will be even better in the future. While I've met hundreds of extremely competent, dedicated executives over the years, there's just something different about the person who scratch-built a company. To him or her, there is no such thing as a better employment offer around the bend. There's no such thing as down time, or weekends, or even hobbies. This company is it. There's no pushing ideas through some big committee. That person is the committee.

Maybe those kinds of companies sound a little risky to you. After all, doesn't classic finance hold that, all else being equal, the smaller a company is, the riskier it is? Well, yes, on a company-by-company basis, those with smaller market capitalizations are riskier in terms of volatility and potential for total loss.

I believe, all else being equal, that this is insane in the aggregate. There is no reason that a portfolio of well-researched, quality small-cap companies should be riskier than one consisting of large-cap companies.

There are several reasons why this is the case, but here are three big ones.

1. The market is only mostly efficient

You may think that with millions of investors watching the market, word will get around instantly whenever a company launches a new product. But a more obscure company that has carved out a clear advantage for itself might take a long time to be recognized. The same is not true of larger-cap companies. It's much more unlikely that we'll get an insight on Apple that dozens of professional analysts don't share. But when my colleague Tony Arsta determined three years ago that Infinera was making a smart long-term decision by skipping a product cycle and focusing on the next generation of network equipment, it was quite some time before Wall Street clued itself in. With smaller companies, an investor can discover things that others don't know.

2. Small caps have more ways to profit and more capacity to grow

There are lots of people who love Apple as an investment, and there are lots of people who do not. But here's something that both camps can absolutely agree on: There is no path by which it will double sales in a year. Well-positioned smaller companies, on the other hand, can show massive operating gains, which tend to (eventually) be reflected in the stock price. In 2009, a basic understanding of Under Armour 's niche and growth prospects would have led investors to buy the company even though it looked expensive.

3. Volatility and uncertainty scare otherwise reasonable people away

Humans fear the unknown, and not only are smaller companies less known, but they are also at greater risk of stumbling than big companies are. That proprietor we talked about? Eventually she has to let go of the reins, as she cannot do everything herself. Tom Glennon, one of the greatest entrepreneurs I've ever known, said there are "$1 million managers" and "$20 million managers," referring to how big of an enterprise he would trust those people to run well. The leaders of fledgling companies are learning as they go, so it's way better to rely on a big company with its systemic management, right? Well, once upon a time, Polaroid and Xerox were large-cap companies, and that didn't save them from tanking and slipping into irrelevance. (Though perhaps their collapses were less volatile.)

Here's what is true: A small cap with great potential cannot succeed with a mediocre boss. Here's another simple truth: In the long term, a well-positioned, professionally run, excellent small-cap company is safer than a poorly run large cap that might be on its way back to being a small cap. After all, the day before they declared bankruptcy, former industry giants Eastern Airlines and Lehman Brothers were small caps.

I am saying all of this now because 2015 was a year in which small caps, almost across the board, underperformed midcaps, which underperformed large caps, which underperformed megacaps. This makes folks who invested in the biggest companies look smart and those who invested smaller look dumb. But over time, focusing on well-positioned smaller-cap companies can pay off big, particularly if you can identify them before the market figures things out. And given investors' relative lack of focus on smaller companies, the market tends to offer more opportunities to find buried treasure in the small-cap space than in the larger segments of the market.

But be alert

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The article Are Small Caps Less Risky Than You Think? originally appeared on

Bill Mann has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Apple, Infinera, and Under Armour. Motley Fool Asset Management manages multiple portfolios that hold Infinera and Under Armour. Try any of our Foolish newsletter services free for 30 days . We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy .

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

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

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