Many retail investors tend to focus on blue-chip stocks, bonds, and mutual funds when building their investment portfolios. Often viewed as relatively stable and reliable, these are popular investments that play an important role in a diversified portfolio. And over the past few years, many mega cap technology stocks have exploded to become the biggest drivers of growth in the market.
But there’s a strong argument for including small-cap stocks, those of companies with a market capitalization of $250 million to $2 billion, in a balanced portfolio. While these stocks can be more volatile, they still can offer unique advantages that we feel you shouldn’t overlook.
Many investors subscribe to the philosophy that diversification can help enhance portfolio stability, with the aim of preventing an investor from over-allocating to a specific stock, sector, or market. Similarly, an investor who is overly focused on large cap stocks is missing out on a much broader universe. By adding small cap stocks to a portfolio, an investor can gain access to stocks that behave differently than blue chips.
For example, small cap companies may often be nimbler in reacting to a changing environment. They can often be more closely tied to local economies and trends than global large cap companies. Geographic and sector-specific diversification can potentially help reduce risk in a portfolio. When large-cap stocks suffer setbacks due to global market conditions, small-cap stocks may be less affected if they rely less on international markets. A lower correlation between small and large-cap stocks may improve overall portfolio efficiency.
Today the hype is all about artificial intelligence and technology, and these stocks have certainly had an outsized impact on market performance in the recent past. From January 2023 to the end of May 2024, just a handful of tech behemoths drove approximately 60% of the S&P’s 40%+ gain. However, this doesn’t mean that small caps have been displaced as a potential source of growth in a balanced portfolio.
Small cap companies are often earlier in their growth cycle than established large cap companies. As a consequence, they could be well positioned to potentially achieve a significant level of growth as they seek to expand markets, boost revenues, and build profitability. Unlike large-cap stocks, which may already be dominant players in their sectors, small-cap stocks may have untapped potential.
There have been any number of academic studies considering the impact of company size on stock performance over the years. In 1992, Eugene Fama and Kenneth R. French introduced their three-factor model (the basis for factor investing and smart beta strategies) that looked at the size effect on performance across Value and Growth stocks and found that smaller size had a positive impact on performance.
According to data collaborated by Furey Research Partners, had an investor put $1 into small cap stocks (similar to the Russell MidCap Index) on 12/31/1925, that dollar would have appreciated to $39,807 by March 31, 2024. Invested in large caps similar to the S&P 500 Index, the $1 investment would have been worth $16,072 on the same date. While the typical investor won’t have a time horizon of such length, today’s average long-term investor saving for retirement may still benefit from an opportunity for outsized growth. However, it’s important to maintain the discipline to withstand short-term fluctuations.
As younger companies with less established businesses compared to their large-cap counterparts, small caps tend to be more sensitive to economic conditions. Therefore, they can be more correlated with economic cycles. In the past as the economy has gone through periods of recovery and expansion, small caps, often with more attractive valuations, have tended to rebound the most during certain periods.
According to CFA Institute research, from January 1984 to April 2024, small caps outperformed large caps by an average of 66 basis points (bps) and 493 bps during recovery and expansion periods, respectively. We find that small companies tend to be more agile and adaptive, hopefully allowing them to pivot more quickly. Many can shift strategies fast and potentially seize opportunities more easily than larger, more bureaucratic companies.
Small-cap companies are often at the forefront of innovation. Smaller firms may not have the constraints or slow decision-making process of larger corporations, potentially allowing them to disrupt industries in unique ways. Whether it’s a biotech company working on cutting-edge therapies or a tech startup developing revolutionary software, small caps are often where you can find ground-breaking ideas in their infancy.
Investing in innovative companies at the early stage offers the chance to pursue significant upside. While many small caps won’t achieve massive success, a few winners have the potential to offset losses and possibly deliver exceptional returns.
Wall Street equity analysts widely cover large-cap stocks, and these securities attract enormous attention from institutional investors. Far fewer analysts cover small-cap stocks. As of March 31, 2024, the average number of analysts covering small-cap companies was 5.5, while the average for large-cap stocks was 19.1.
We believe the lack of scrutiny can create opportunities that savvy investors can exploit. When a small-cap stock isn’t followed by any analysts, there’s the possibility for untapped potential that hasn’t been fully priced in by the market. The potential for gain may exceed that in the large cap space, where every development is rapidly priced in due to the wide analyst coverage, the financial news cycle, and higher trading volume. Because of these inefficiencies, active managers may have a greater opportunity to seek excess returns.
While small-cap stocks can be attractive for investors seeking higher growth potential, there are notable risks. Volatility is one concern. Their smaller market capitalization makes them more sensitive to market swings, economic uncertainty, and company-specific issues.
Another critical risk is liquidity. Smaller companies typically have fewer shares publicly traded, which can make it more difficult to buy or sell securities at your preferred price. Low liquidity can result in wide spreads or difficulty exiting a position, especially during a downturn.
Small-cap companies may also have a limited financial history. They may lack robust cash flows, profitability, or operational track records. This makes it more challenging to assess their long-term stability or potential resilience during economic downturns. There may be significantly less publicly available information about these companies, particularly since many small-cap companies are not covered by Wall Street analysts.
Small-cap stocks tend to carry higher risk, and they can be more susceptible to market volatility. However, you can seek to mitigate this risk based on your investment goals and timeline.
If you’re investing for retirement or a long-term financial goal, small caps can play a vital role in seeking greater returns over time. We’ve seen that in some cases they have outperformed large caps over the long run, so they could be an attractive choice for young investors or anyone who plans to hold portfolio stocks through market ebbs and flows.
You can also seek to mitigate risk by diversifying within the small cap space. Rather than investing in individual stocks, consider investing in small-cap ETFs. These options can offer exposure to a range of small-cap companies and help reduce the impact of underperformance by any one investment.
If you’re considering adding small caps to your portfolio, here are a few tips to get started:
Adding small cap stocks to your portfolio can be a smart move when you’re seeking long-term growth and diversification. These stocks can have the potential to offer a unique blend of high possible returns, geographic and sector diversification, plus the chance to benefit during economic recoveries.
While no investment is without risk, we feel small-cap stocks deserve a place in any diversified portfolio. By understanding the advantages and balancing the risks, you can invest in small caps as part of a well-rounded investment strategy.