Small is beautiful.
Source: Judyta Frodyma
That’s what I thought when I looked at a chart of long term stock market returns. Small cap stocks have grown significantly more than large-cap stocks over the long haul. But they do so at the cost of higher volatility. And that makes sense. Small companies have more potential for growth than large firms, but they don’t have the big bank accounts or sophisticated risk management systems that big companies do, either.
Source: Karsten Investments
Over time, the benefits to investors can really add up, if they can handle the added volatility. Because of this, the “size effect” has been discussed by academics since the early 1980s. If it’s so hard to beat the market, why do small companies outperform so consistently? Why don’t institutional investors take advantage of these higher returns and make them go away?
Some claim that the size effect is mainly a matter of liquidity. Small stocks are less liquid than their big brethren. When institutional orders come in to buy, the investor gets poor execution and doesn’t get the benefit of the small size and higher growth potential. By this analysis, the size effect is a mirage: when you actually try to touch it, it disappears.
But there are reasons to believe that size matters. Good quality small companies can grow up to become world-changing disruptors. Even boring small companies can return a lot of cash to their owners. That’s the whole idea behind venture capital and angel investing. Get in on the ground floor, and ride the elevator up. But venture investing is hard work: you have shuck a lot of oysters to find the pearls.
The same logic applies to publicly-traded small cap stocks. If you look for quality—good management, strong financials, growing markets—small really is beautiful. In other words, once you sort them out, small cap stocks really shine.
Small stocks can be a valuable part of a diversified portfolio. Especially if you’re small yourself.
Douglas R. Tengdin, CFA
Chief Investment Officer
Leave a comment if you have any questions—I read them all!