Small Cap Stocks Can Offer Big-Time Performance

smallcapDo you own any stocks with market capitalizations under $300 million, $500 million, or even $1 billion? If not, chances are you’ve been missing out.

I was reminded of the power that’s packed into small stocks last week in Philadelphia, where I attended The MicroCap Conference. The two-day event featured seven expert micro-cap speakers … over 60 companies … and 300-plus investors.

Getting this up-close look at innovation, and the profit potential behind many of these ideas, was inspiring.

Now, you don’t want to put your capital to work in a company based on one single factor like size. But seeing what kind of big things can come in small packages was a timely reminder of why investors should consider including micro-cap stocks as a piece of their asset-allocation pies.

Here are five important reasons why micro-cap stocks deserve a spot (albeit, a small one, for most investors) in your portfolio.

No 1: Micro-caps outperform their bigger-cap pals (small- and large-caps) over the longer term.

Micro-caps outperform in long-dated, high-return cycles… long-dated, low-return cycles… and over the long term, in general.

Source: Ibbotson Classic Yearbook, 2015

Let’s translate this outperformance into dollars. Just $1 invested in each of three market-cap slots over the last 90 years (12/31/1925 to 12/31/2015) would amount to $5,376 for large-caps, $17,146 for small-caps and $28,831 for micro-caps.

No 2: Micro-caps are off Wall Street’s radar.

Wall Street doesn’t want to waste its time reporting on little companies. That means plenty of neglected opportunities exist in this part of the market.

Source: Furey Research Partners, March 2016

Stocks with market caps between $300 million and $3 billion attract just 7% of analyst coverage.

If you go below the $300 million market cap, analyst coverage is a miniscule 2%.

No 3: Micro-caps have the highest degree of insider ownership.

When insiders own big stakes of a company, they have their own monetary incentives at stake.

So, not only are they trying to create long-term value for investors … they want to pad their own wallets, as well. High insider ownership means the interests of company management and investors are aligned.

Source: Furey Research Partners, March 2016

Various studies have shown that stocks with high insider ownership perform better than stocks without such ownership. If you’re seeking out the benefits of strong insider ownership, micro-caps and small-caps hold a sizable advantage in this area over mid-caps and large-caps.

No 4: The highest probability of takeovers happens at the micro-cap level.

Bigger companies buy smaller companies. So, the following chart should make sense …

Source: Furey Research Partners, March 2016

Over 60% of public M&A deals occurred at the micro-cap level (below $300 million market cap). And more than 90% of public M&A deals took place in the micro-cap and small-cap space, combined (below $3 billion market cap).

This means it’s wise to hunt for takeover candidates in smaller-capitalization stocks.

Typically, takeovers result in big paydays for shareholders. Barron’s calculates an average acquisition premium of 24% from 1984 to 2013. And FactSet reports a median takeover premium of over 30% in the last two years.

No. 5: Micro-caps offer portfolio diversification.

Small company stocks have low correlations to other asset classes (including large company stocks). Correlation measures the relationship between two different asset classes under the same market conditions.

Source: FactSet

Micro-caps and smaller-caps stocks — with their lower correlations — make good diversifiers.

There are two other important reasons to own smaller-sized stocks in today’s market environment …

First, micro-caps have performed better than other capitalization stocks in low-growth environments (like we’re in now).

For example in the 1930s, when real GDP growth averaged 1% … large-caps averaged a -0.1% return, small-caps averaged a +1.4% return and micro-caps averaged a +6.8% return.

And again in the 2000s, when real GDP growth averaged 1.7% … large-caps averaged a -0.9% return, small-caps averaged a +6.3% return and micro-caps averaged a +8.3% return.

And second, smaller-cap stocks perform well after rate hikes (a future rate hike(s) is inevitable).

The Russell 2000 Index has averaged a +15.6 return 12 months after initial Fed Funds rate increases from 1980 to 2004.

OK, those are the five main reasons — and a bonus two reasons applicable to the current environment — why you should consider carving out a small piece of your asset allocation framework for micro-cap stocks.

Here are some micro-cap funds to consider:

1.) ETFs:

  iShares Micro-Cap ETF (IWC)

  PowerShares Zacks Micro Cap Portfolio ETF (PZI)

  Wilshire Micro-Cap ETF (WMCR)

2.) Top actively managed mutual funds (all four have outpaced the Russell Micro Cap Index over trailing three-, five- and 10-year periods):

  Oberweis Micro-Cap Fund (OBMCX)

  RBC Microcap Value Fund (TMVAX)

  Wasatch Micro Cap Value Fund (WAMVX)

  Westcore Micro-Cap Opportunity Fund (WTMIX)

Remember, sometimes, it pays to think small.

This article is brought to you courtesy of Uncommon Wisdom Daily.

About the Author: Grant Wasylik

grant-wasylikGrant Wasylik is an analyst and editor for Uncommon Wisdom Daily — a division of Weiss Research.

Before joining the investment newsletter business, Grant worked as a portfolio manager, lead research analyst and head trader for a billion-dollar wealth management firm for 10 years. He also spent a few years working in a specialized risk-trading department at Charles Schwab — where he was the first-ever, external hire into this elite department. In his first stint in the securities business (after passing Series 7, 64 and 24 exams), Grant ran a margin department and supervised a trade desk for a discount brokerage firm.

Prior to coming to Uncommon Wisdom Daily, Grant was co-editor and chief analyst of The Palm Beach Letter for two years. This monthly publication — with over 70,000 subscribers — focused on safe, income-oriented investments.

Due to his vast investment experience, Grant has a deep contact list comprised of 400-plus mutual fund, ETF, index, hedge fund and other top-notch financial professionals. In addition, he receives special invitations to — and attends — several of the world’s top investment conferences each year.