Don’t Follow The Herd, Go For Small Caps

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David Evanson and Oliver Pursche

Forbes.com, Summer, 2013

Ah, the vicissitudes of the market “herd.” Consider Apple: its iPad is crushing Samsung, Google’s Android in the tablet market, but the stock is down almost 40% from its high last year and it has made a series of missteps that have upset investors, including large losses on its record breaking $17 billion bond offering.

The disgruntled herd has stampeded away, although it hasn’t really gone that far. I have been noticing a sub-trend this year as investors continue to show a bias towards large-cap firms as the S&P 500 continues to trade at all-time highs having broken through the 1,700 level. And as Jeff Kleintop of LPL said, I don’t think it’s going to be the last time we say “all time high” this year.

However, I advise moving against the herd because they’re overlooking the potential of small caps, which I believe could become (actually, remain) market leaders.

It’s simple: small companies typically outperform over time because they have greater growth prospects than the market leaders. Between 1927 and 2012, small caps produced annual returns of 12.9%, compared with 9.9% for large companies.

Notice that the iShares Russell 2000 Value Index (IWM) has gained 24.8% this year compared with 19.7% gain for the S&P 500 over the same period.

As a side note, please beware the so-called small-cap funds that aren’t really full of small caps. According to Lipper, 211 out of 476 actively managed small-cap funds owned companies with market capitalizations of $10 billion or more—well over three times the cut off most managers consider the top end for small caps.

You should check fund holdings through Lipper or Morningstar periodically to make sure they match up. Otherwise the money you invest to diversify into small caps might really be doubling you down on large caps.

Overall, small-cap stocks outperform their large-cap brethren and their fundamentals and valuations remain more attractive. Moreover, revenue growth and future growth expectations for small-cap stocks continue to be stronger than for large-cap multi-nationals who are facing additional headwinds resulting from a stronger dollar, which reduces the value of internationally generated profits.

For example, WD-40 (WDFC) is a global consumer products company with a market cap of $899.8 million. Its large cap competitor, Church & Dwight is considerably larger with a market cap of $8.5 billion, yet WD-40 sports a lower P/E and a higher dividend yield.

Likewise, Foot Locker’s direct (and larger) competition Dickzzs Sporting Goods has a higher P/E and lower dividend yield.

Many of the lower-volatility small-cap stocks also have better profit margins than their large-cap counterparts. While many large companies have improved margins and profits through aggressive cost cuts, small-cap stocks have done so through product innovation, international expansion, and growing their business overall.

Picking individual stocks is hard work and those appropriately cowed by the process should keep in mind the principles making small caps attractive at the moment also applies to baskets of them. Accordingly, the Vanguard Small-Cap Value Index (VISVX) and the Russell 2000 merit consideration for investors’ trying to stay one step ahead of the herd.