The Smaller the Better: Investing in Micro-caps

Since 1926, micro-cap stocks have beaten large caps by an average of 3 percentage points a year.

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When it comes to stock investing, sometimes it pays to think small. Over the long term, investors have been rewarded for allocating a small portion of their portfolio to micro-cap stocks—companies with a market capitalization of less than about $740 million, according to Morningstar.

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These smaller companies may not be as recognizable to the average investor, but they pack a major punch. Since 1926 through the end of February, micro-cap stocks have returned an annualized 12.3 percent, about 3 percentage points more than large-caps stocks over the same time period, according to data from the University of Chicago provided by Artio Global Investors. By comparison, small-cap stocks have returned an annualized 11.5 percent over that period, while mid-caps returned an annualized 11.1 percent.

Generally, small companies lead when the economy begins to recover, then the rally transitions to large-cap stocks, says Adam Bold, founder of the Mutual Fund Store, an investment firm. Over the past three years, the Russell 2000 Index of small-cap stocks has returned an annualized 9 percent as of the end of March. Meanwhile, the S&P 500 has returned just 2 percent over the same period of time.

Higher returns, of course, come with more risk. "The tradeoff is, yes, you get long-term outperformance ... but the volatility of returns is greater," says Samuel Dedio, manager of the Artio U.S. Microcap Fund (symbol JMCAX). "That's the price you pay if you want exposure to a better-performing asset class."

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Small- and micro-cap stocks make up the riskiest slice of the U.S. stock market. Little is known about many of the companies, but that can be an advantage for investors. Over time, small companies can grow much more than larger, more established companies. And while a big S&P 500 company may have dozens of analysts tracking it, a micro-cap stock may be covered by just one or two analysts. "Lots of them are brand-new companies," says Brian Culpepper, comanager of the James Micro-Cap Fund (JMCRX), which leaves room for experienced managers to do their own research to find undiscovered companies.

Opinions are mixed about whether the rally in smaller stocks still has legs. So far this year, the Russell 2000 has outpaced the S&P 500 by about 2 percentage points. Dedio and Culpepper both believe small stocks have some room to run, given that many companies' balance sheets remain flush with cash, and merger and acquisition activity is picking up. "Any time the bigger caps have a ton of cash on their balance sheets, that looks pretty good for the smaller stocks," Culpepper says. The best small companies are often bought by bigger firms.

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But the U.S. economy has officially been expanding for months now, and some market watchers say it may be time for investors to rebalance their portfolio with a bigger position in large-cap stocks. "The easy money in small caps has been made," Bold says. "For people who have had small caps that have run up a lot, now is the time to rebalance a little bit and take some of the profits from small caps and put them into large caps."

Still, it's never wise to try to time the markets, says Morningstar analyst Greg Carlson. He recommends keeping a small allocation to small stocks regardless of the market environment, depending on your risk tolerance and time horizon.

Twitter: @benbaden