Let’s start with one of the best ways to think about small-caps, from none other than Warren Buffett. Her are Buffett’s thoughts on investing in small-caps:
“If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50 percent a year on $1 million. No, I know I could. I guarantee that.
The universe I can’t play in has become more attractive than the universe I can play in. I have to look for elephants. It may be that the elephants are not as attractive as the mosquitoes. But that is the universe I must live in.”
Now, the Russell 2000 index is off 5% year-to-date and now down 12% in just the last year. Meanwhile, the S&P 500 is only down 1% over both periods.
But have no fear, small-cap stocks are fine. Over the long-term they’ll still treat you right and if you pick the right ones they’ll do just as well in the short-term. This starts with focusing on value.
From 1926 to the mid-2000s, small-cap value stocks grossly outperformed large-cap growth. Large-cap growth stocks posted an average return of 9.3% from 1926 to 2004. The small-cap value stocks meanwhile are up 15.9% over the same period. Ibbotson has put together some work that shows small-cap stocks have outperformed large-cap stock almost 80% of the time over a 15-year period and 95% of the time over a 20-year period.
Source: KeyStone Financial
We’ve been though the reasons that small-caps outperform before - dubbed the Six Small-Cap Laws - which includes size and growth rates. It’s inherently easier for a company to double earnings from $100 million to $200 million ,rather than from $1 billion to $2 billion. The best companies start out as small-caps. This includes the likes of Wal-Mart and Microsoft. But again, there are a lot of small-caps out there and the risk/reward profiles are all over the spectrum. Don’t get caught buying overpriced small-caps or hold onto looks for too long waiting for a turnaround.
Don’t forget, this is part of our small-cap coverage for underrated small-cap hedge funds. This starts with the free small-cap email newsletter - non-spammy and non-penny stock - we highlight ideas you won’t find elsewhere.
P.S. We’re turning Underrated Small-Cap Stocks into a subscription service that profiles underrated small-caps and under-the-radar hedge fund managers. We’re fishing in a pond where there are fewer fishermen. The idea is to profile managers that have a history of outperforming. And with that, our upcoming April issue features a manager that’s managed to generate 15%+ annualized returns since inception. His bread-and-butter is on finding micro-caps with impressive upside - learn more here.