3 Small-Cap Myths

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Senior Investment Strategist Steve Lipper discusses three misconceptions investors may have about small-cap stocks.

Steve Lipper On 3 Small-Cap Myths

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As we talk to investors about investing in small cap we're actually surprised at how pervasive a number of misunderstandings are about the asset class. They're so common that we actually refer to them as small-cap myths because the facts suggest otherwise. The first of those misunderstandings or myths is how small our small cap companies. So if you ask someone well what do you consider a small company. They might say well a company of 50 or 75 or maybe 100 people I'd consider that a small company might surprise people to know that the median Russell 2000 company has nearly a thousand employees. That's pretty significant. Now let's take a look at revenue. We asked again someone What do you consider a small company but still absolutely viable. What might they have in revenues a 50 million year seventy five one hundred million. Well again the median small cap company had over 400 million in revenue over the last 12 months. Over 400 million in revenue and nearly a thousand employees. That's much larger than most people would think. A small cap company is one of the interesting things about small cap and probably one of the most underappreciated aspects of it is the diversity within the small cap universe. So many characterizations of small cap we would say Well that's true yes. And in the end is that there are many exceptions. Let's look at quality from three different parameters. Let's look at it from profitability.

Let's look at it from dividends. And look let's look at it from balance sheet leverage and let's hold small companies to the standard of large companies and say how many small companies were above average on those parameters. So small cap return on equity. There are 400 over 400 small cap companies had had higher Aro ease over the last 12 months than the average large cap company in terms of dividend paying. There are over 800 small cap companies that are paying dividends. And in terms of balance sheet leverage and this will surprise many people there are over twelve hundred small cap companies that have lower leverage than the average large cap. So it is true if we look out of the Russell 2000 net not all of them have high profitability pay dividends or have low leverage but it's also true that hundreds of companies do. Whenever we're talking to prospective investors about small caps we encounter the topic of risk. While it is absolutely true that small caps have a higher level of volatility historically than large caps do would suggest that investors might look at risk in another way. You might consider it around what's the probability of loss in this investment. And while we can't be certain about the future the past can somewhat inform those probabilities.

So there is a research organization in Chicago called Center for Research into security prices that has tracked the performance of the small cap asset class back decades. So we took a look all the way back to 1945 and said what has been the experience of loss the probability of loss at different holding periods. We would suggest that someone is considering a small cap investment that they consider at least 3 5 or hopefully 10 years. What is the last seventy five years of history show us about that the probability of loss on three year holding periods for small caps has been only 12 percent. Eighty eight percent of the time small caps have made money over three year periods for five year periods it's ninety five percent of the time and 10 year holding period since 1945. One hundred percent of the time small caps have made money. Does that guarantee in the future. No it does not. However we would suggest that those are probabilities that are much higher than some investors would consider and that may frame what their own view is about the opportunity the risk versus the reward of investing in small caps.

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