Small caps are no longer a big deal

May 19, 2006

Investment Consult

"Go where the action is" might be a useful mantra for life, but it may not be the wisest motto for investing.

That may soon be the case with small-cap stocks. They've performed quite well in recent years. The S&P SmallCap 600 Stock Index has brought in one- and three-year returns of 24.1 and 30.0 percent annualized, compared to the more sedate S&P 500 Stock Index (comprised of large companies), which shows one- and three-year returns of 11.7 and 17.2 percent annualized.

You'll also find that small companies have greater growth-spurt potential, since they're starting from a smaller base. New companies spring up all the time. Some go under, others get gobbled up by larger companies, and some thrive. Trying to find "the next Microsoft" in its near-infancy has become part of the fabric of American life.

Now for the downsides. Small-caps are more volatile than large-caps. The standard deviation (which indicates the typical variability of returns) of small-caps is 14.0, compared to 8.8 for large-caps. And since savvy investors have jumped on the small-company bandwagon, the category is no longer cheap. For instance, shares of the Vanguard Small-Cap Index Fund have jumped 104 percent since 2002. That's more than twice the rate of growth of Vanguard's 500 Index Fund over the same period.

As a result, I believe the return potential for small-caps in the coming three years is probably about the same as that for large-caps. Yet you incur more risk owning small-caps.

You should indeed keep small-caps in your portfolio. Just don't overweight them. Stay at or just below the optimal allocation you chose when you originally developed your portfolio.

The best way to own small-cap stocks is through a mutual fund. However, small-cap funds have been so popular in recent years that many of the most attractive funds have closed to new investors. The Baron Small Cap Fund, American Century Small Company Fund, Third Avenue Small-Cap Value Fund, and numerous other really good small-cap offerings now only allow current shareholders to invest more.

But some good, well-diversified selections remain. The Royce Opportunity Fund (Investment Class) has a nice, value flavor to it. Its portfolio managers sometimes buy shares of stocks that have no earnings, or have earnings disappointments, with confidence that profits will show up in the future. The fund has performed well, with one- and three-year annualized returns of 27.8 and 38.3 percent. The portfolio's average market cap is $485 million, which means its holdings are generally on the smaller side of the small-cap range. And indeed, the fund does invest in micro-cap as well as small companies. Those factors keep the fund share price reasonably low.