Lately, the stock market has been dominated by a handful of behemoths. Tech giants and household names have propelled indices to new heights, leading many investors to make outsized allocations to these large-cap leaders.
While the performance of these mega-companies has been impressive, looking only at the top of the market could lead to missing out on a powerful engine for potential growth: small-cap stocks.
Despite the attention focused on larger peers, we believe many quality small-cap stocks continue to offer a compelling opportunity for investors seeking significant growth potential as well as diversification and long-term value.
Let’s talk about why these smaller companies deserve some attention, including their historical performance, unique growth drivers, and how small caps could strengthen a portfolio.
Uncovering Small Caps’ Potential
What exactly is a small-cap stock? The definition varies, but generally the term refers to companies with a market capitalization between $300 million and $2 billion.
These aren’t startups, but established businesses that are smaller relative to megacaps. Many believe them to be among the nimblest companies in the economy because they’re often capable of quick pivots and rapid acceleration. Large caps, which many generally believe to have less volatility on average than small-caps, may not have the same ability to change course quickly when the market does.
Their size is precisely where we feel small caps’ strength lies. They are often younger, considered more innovative, and operate in niche markets with potential for substantial expansion.
Engines of Economic Growth
Large companies can be great at optimizing and scaling, but we think small companies are often where true innovation can come to life. Their agility can allow them to adapt to new technologies and shifting consumer behaviors more quickly than many of their larger, more bureaucratic counterparts. This ability to move fast can potentially contribute to growth.
It’s also simple math. A large, established company with $50 billion in annual revenue needs to generate an additional $5 billion in sales to achieve 10% growth. In contrast, a small-cap firm with $500 million in revenue only needs to find $50 million in new sales to achieve the same growth rate. Theoretically, with all else being equal, the bigger the company, the more revenue they need to achieve a given growth rate.
This dynamic is a core reason why small caps have historically delivered attractive returns over the long run according to data from July, 1926 to December 2021.1 They’re in the high-growth phase of their business lifecycle, reinvesting profits to fuel expansion, develop new products, and capture market share.
The Size Premium
The concept of the size premium, long discussed in academic finance and highlighted in the Fama-French Three-Factor Model, suggests that small cap stocks have the potential to outperform larger stocks over the long term.2
Indeed, it is one of the factor premia (some others include value and momentum, for example) regularly used in factor investing, a data-driven strategy that bases security selection on measurable characteristics that have historically been associated with higher returns or particular risk profiles.3
Historically the size premium has been cyclical, with alternating periods of outperformance and underperformance. The average cycle of outperformance for large caps is 11 years, but we’re currently experiencing the fourteenth year of large-cap outperformance.
However, small caps are currently trading near record low valuations, and, while past performance never guarantees future results, many professional investors are predicting small caps may soon see earnings growth outpace that of large companies.4
Small caps can be volatile
Of course, the potential for outperformance comes with higher volatility. Small-cap stocks are generally believed to carry more risk than large-caps. Their share prices can swing more dramatically, and they’re more sensitive to economic downturns.
However, for investors with a long-term horizon, this volatility can be an advantage. Periods of market fear often can present opportunities to buy shares in high-quality small companies at a discount.
Over time, the superior growth prospects of these smaller firms can compensate investors for the additional risk. We believe the key is patience and a long-term perspective, allowing the growth stories of these companies to unfold.
Small Caps Can Offer Diversification Benefits
Focusing your portfolio on a few large-cap outperformers can feel safe when they’re doing well. However, this creates concentration risk. If sentiment turns against a specific sector, like technology, or if one of the mega-companies falters, a portfolio heavily weighted toward these stocks can suffer significant losses.
The small-cap universe also offers investors a much broader and more diverse set of investment opportunities, including increased sectoral and geographic diversification. Consequently, adding small-cap stocks to your portfolio can provide powerful diversification benefits. Small-cap performance is often driven by different factors than large-cap performance. For example:
- Domestic focus: Many small-cap companies derive the majority of their revenue from the country in which they’re based. This can help insulate them from global trade disputes or currency fluctuations that might negatively impact large multinational corporations.
- M&A activity: Small caps are often attractive acquisition targets for larger companies looking to acquire innovative technology or enter new markets. An acquisition can result in a significant premium for shareholders in the smaller company.
- Less analyst coverage: Unlike the big names that are scrutinized by dozens of Wall Street analysts, many small caps lurk under the radar. This information gap creates opportunities for diligent investors to find undervalued gems before they become widely known.
By including small caps in a portfolio, it’s possible to help spread risk across companies of different sizes, geographic exposures, and stages of growth. This can help lead to a smoother overall portfolio return over time.
Finding the winners in a crowded field
Investing in small caps requires more research than simply buying a well-known blue-chip stock. Since they are often less covered by the financial media, it’s necessary to do more legwork to identify promising companies. Focus on businesses with:
- Strong balance sheets: Look for companies with manageable debt levels.
- A clear competitive advantage: What makes this company special? Does it have a unique product, patent, or business model?
- Proven management: An experienced and capable leadership team is crucial for navigating the challenges of growth.
- A large addressable market: The company should have a significant runway for expansion.
For investors who don't have the time or expertise to pick individual stocks, small-cap exchange-traded funds (ETFs) or mutual funds can be an excellent option. These funds provide instant diversification across hundreds or even thousands of small-cap companies, making it possible to benefit from the asset class without needing to become an expert stock-picker.
The Takeaway
The dominance of large-cap stocks has been a major story, but it's not the only story. While the giants of the market can potentially provide lower volatility, the smaller, dynamic companies in the small-cap universe can offer the explosive growth potential that can supercharge a portfolio over the long term.
By providing powerful growth, historical outperformance, and crucial diversification, we feel small-cap stocks remain a vital component of a well-rounded investment strategy. Don't let the headlines distract you. The next big thing in your portfolio might just be a company you haven't heard of yet.
5 min read
