Portfolio construction involves three main decisions. First, there is the composition percentage of U.S. and foreign stocks. Second, whether they follow a growth or value orientation and third, the market cap of those stocks. Often overlooked by investors, small-cap stocks are companies with market capitalizations between $300 million and $2 billion. Considered risky by some, they are the growth engine of the economy. Starting out as saplings, many become giant oak trees over time. Overwhelming evidence suggests a diversified stock portfolio should include a portion in small-cap companies. Read on and I'll explain why.

TUTORIAL: Stock Basics

Historical Performance
Dimensional Fund Advisors produces an annual matrix book that summarizes historical risk and returns of various indexes based on market capitalization. Not surprisingly, the best performing index over an 80-year period (1931-2010) is the Small-Cap Value Index. It's also the hands down winner over 50, 10, 5 and one-year periods. Eugene F. Fama, Jr., who's father is the creator of the efficient market hypothesis, suggests that the only way to increase expected returns, is by exposing your portfolio to greater systematic risks. However, what constitutes risk is somewhat variable. Morningstar studied four hypothetical portfolios in "The Perfect Mix of Large-, Mid-, and Small-Cap Stocks" over a 30-year period (1976-2005), and found that the portfolio comprised entirely of large-cap stocks (which Morningstar defined as over $5 billion market caps) had exactly the same risk profile as the portfolio with 40% large-cap, 30% mid-cap and 30% small-cap. The portfolio with a mix of stocks achieved an annual return 2.1% higher. A $10,000 investment in the large-cap portfolio would have been worth $327,000 after 30 years, compared to $573,000 for the mix of stocks. Volatility, while real, is sometimes exaggerated. By taking no additional risk, an investor is able to improve his or her annual return simply by diversifying into stocks of smaller companies.

Why You Should Include Small-Caps In Your Portfolio
Although historical returns are an excellent reason to own small-cap stocks, there are many others. Here are just a few:

  • Small-cap stocks are often too small for institutional buyers to own, giving individual investors the opportunity to get in on the ground floor before the stocks become a household name. Then, as the stock grows in size, institutional investors take notice and start buying. When that happens, things really get interesting.
  • By investing in smaller companies, you're helping some of America's most innovative businesses to grow. Many of today's best large-caps started out as small businesses. Without your investment, they might have stayed that way.
  • Many Wall Street analysts don't cover small-cap stocks. With little institutional coverage, only those investors carrying out their own research will even know that some of these companies exist.
  • Small companies have fewer employees and lower expenses. This enables them to take greater risks that larger companies just can't do. Furthermore, because they have the flexibility to chase growth trends, when and if they see fit, they can react far more quickly to potential opportunities. Often this first-mover advantage is critical to long-term success. Large-caps simply don't move this fast.
  • Small-caps grow more quickly because of their size. A restaurant chain taking a city by storm that expands to other large cities, outside its initial market, is going to double its sales much faster than a large-cap with $20 billion in revenue. It's the nature of the beast. (Learn more on making investment decisions based on firm size, check out An Introduction To Small-Cap Stocks.)

Growth Vs. Value
Every experienced investor has his or her own definition of what makes a value and growth stock. The most common being that growth stocks are companies whose earnings are rising faster than the market; while value stocks are those businesses whose growth is slower than the market, and thus falling out of favor with investors. Growth investors tend to look for companies with price/earnings to growth (PEG) ratios lower than one, while value investors are more apt to choose those with low price-to-book (P/B) and price-to-earnings (P/E) ratios. An interesting way to determine investment style is to add together a stock's P/E and P/B ratios relative to the S&P 500.

For example, Company A has a P/E of 50.5 and a P/B of 6.3, for a total of 56.8. Now, let's assume that the S&P 500's P/E and P/B ratios added together totals 15.5. The sum of Company A's ratios is 3.7 times that of the index. Any stock with a sum of 2.25, or higher, relative to the index, is considered a growth stock; less than 1.75 is a value stock, and those in between are a blend of the two. Not only is it important to diversify by market cap, sector and industry, history tells us that it's also useful to achieve some sort of balance between growth and value because of the cyclical nature of both types of stock returns. When value is outperforming the markets, growth stocks aren't and vice-versa. (Learn more in Using The Price-To-Book Ratio To Evaluate Companies.)

Attributes of a Winning Small-Cap
The answer to this depends on whether you're looking for a growth or value stock. If you're interested in growth, the biggest attribute revolves around a company's income statement. Ideally, you want a company whose revenues and earnings are growing at 15 and 20% per year, respectively. In conjunction with the revenue and earnings growth, you'll be looking for companies whose margins are expanding rapidly, have little debt in their capital structure and are using more cash than they bring in. In other instances, you might accept less revenue and earnings growth in return for greater cash flow generation. The key for most growth investors is a valuation that exceeds small-cap indexes, like the S&P Small Cap 600 or the Russell 2000. On the other hand, if you're looking for a value stock, it's all about the price you pay. These are often companies misunderstood by the markets, or relatively unknown, and competing in niche industries. Here, revenue and earnings growth is less important. Instead, value investors look for companies with strong management, excellent balance sheets, positive cash flow and valuations below the index. Over time, value tends to outperform growth. This doesn't mean, however, that you should include only value stocks when constructing your equities portfolio. Diversification is always a good thing, whether we're talking geography, investment style or market cap.

Stocks, Mutual Funds or ETFs
Investing in individual stocks is much easier, today, than it once was, and as a result, more individuals are managing their own portfolios. The most important thing for do-it-yourselfers to keep in mind, when investing, is to avoid unsystematic risk, which is the risk associated with investing in a particular company. Most professionals believe you can eliminate much of this risk by owning at least 15-20 financially sound companies. If you don't have the funds to invest in this many stocks, it might be better to purchase, either, exchange-traded funds (ETFs) or mutual funds. Which one is right for you? This depends on what you are trying to accomplish. For example, if you're making a one-time purchase due to a financial windfall, the commission costs involved in buying ETFs, which trade like stocks, shouldn't be too prohibitive. However, if you are looking to make a small monthly contribution from your paycheck, mutual funds might be a better, less costly alternative. Furthermore, your mutual fund company will automatically reinvest dividends at no cost while ETFs involve trading commissions. Whichever option you choose, small-caps are an excellent way to boost your investment returns. Just don't forget the risks. (Check out An Introduction To Exchange Traded Funds.)

The Bottom Line
Small-cap investing, when done correctly, can improve the overall performance of your portfolio without adding a great degree of risk. In the end, success comes when these smaller companies grow into larger ones. It doesn't happen all the time, but frequently enough to seriously consider making them an important part of your portfolio.

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