In one sense, the investor fails to consistently receive excess returns over the market average. Headlines and portfolios of markets are filled with large-cap stocks, but smaller companies often outperform. The implication is that most investors are missing a strategy for benefiting from the small cap effect.
The small cap effect or small cap premium postulates that smaller companies would outperform their bigger peers over a longer period. This phenomenon has an empirical basis and is an essential component of the Fama-French three-factor model, which tries to explain stock returns from size, value, and market risks.
We start discussing here the small cap effect and a strategic way to exploit such an effect. It may be one’s best-positioned opportunity to be able to beat 99% of investors, or at least, come close to that figure, with investing in small cap stocks-especially those with strong value and quality characteristics. Let’s unpack the data and strategies that make the small cap effect a compelling addition to your investment strategy.
Understanding the Small Cap Effect
The small cap effect is rooted in evidence that small firms gain higher returns than large ones over longer horizons. Such an effect has abundant evidence since at least the 1960s, thereby allowing investors access to a large dataset.
Historical Performance
Data from 1963 to the present further shows that small cap stocks have outperformed large caps, especially when investors sideline the most egregious offenders among small cap stocks. A marginally larger gap exists between small cap value and small cap growth stocks.
As far as performance comparison is concerned, it has been evident that small cap value stocks have been consistently outperforming the small cap growth stocks since 1940. The long time trend depicts the effectiveness of investment in small cap in value investing.
Value and Quality in Small Cap
If you invest in the small-cap market with an emphasis on value and quality, you can improve your prospects of returning value on investments.
Small Cap Value vs. Small Cap Growth
Small cap value stocks, as the term itself reveals, are those securities trading at lower price-to-earnings or price-to-book ratios. Generally, small cap value stocks generate better returns compared to their growth-oriented counterparts. This is attributed to several reasons, as mentioned below:
- Undervalued Opportunities: Generally, many small cap value stocks portray undervalued companies with a potential to pick up during their journey. Undoubtedly, the scenario attracts long-term investors.
- Market Inefficiencies: Smaller companies are relatively less covered by analysts and the financial media. The lack of coverage results in mispriced stocks. Selective investors can take advantage of these inefficiencies to collect huge profits.
Quality Factor in Small Caps
The quality factor refers to investments by companies that are characterized by strong fundamentals, including high profitability, stable earnings, and a low debt level. A conclusion from a research study points out that high-quality small cap stocks, also known as “robust” stocks, perform dramatically better compared with their non-quality counterparts.
- Investment Implications: Combining the small cap effect with a focus on quality could improve your return while potentially lowering your risk.
Small Cap Effect Strategy Construction
For the small cap effect, you will need a defined strategy in which we have discussed the insights. Here’s a step-by-step approach:
1. Define Your Investment Universe
First, you select a broad universe of small cap stocks. Typically, these stocks would be those whose market capitalization is less than $2 billion. You can use stock screeners that filter through small cap stocks and screen out some to meet your criteria.
2. Screen for Value
Once you have your universe of small cap stocks, use the following metrics to screen for value:
Price-to-Earnings Ratio (P/E): The stocks of companies with lower P/E ratios than their peers qualify
Price-to-Book Ratio (P/B): Companies with lower book value qualify
Dividend Yield: Companies with higher dividend yields qualify as value plays
Step 3: Quality
Assess the quality of companies in your universe.
- Profitability: Try to seek companies with high profit margins and return on equity.
- Earnings Stability: Seek firms that provide a history of consistent earnings growth over several periods.
- Debt Levels: Target firms with manageable debt-to-equity.
- Diversification
To be able to mitigate a significant risk, a small cap investment portfolio must be diversified across different sectors and industries as much as possible. This spreads out the risk of individual stock volatility but also takes advantage of diverse growth cycles around the economy.
5. Track and Adjust
You will track your small cap stock portfolio regularly due to changing conditions in the market and one should regularly reassess one’s holdings versus one’s investment criteria; you might sell poor-performing equities and reinvest in better opportunities.
Long-term Benefits of Investing in Small Caps
Here are the advantages of investing in small cap stocks for the long run:
1. Greater Gains
Small caps have performed well in the long run compared with large caps. Their ability to seek superior potential returns means they are worth adding to your investment list.
2. Higher Growth Eligibility
The potential growth of small companies can be considerably more significant than that of large capital. This aspect of growth can go a long way in dishing out massive appreciation of capital.
3. Lower Correlation with Large Caps
Small cap stocks generally exhibit behaviors that are a good bit different from large caps, so they will add a diversification benefit to your overall portfolio. This means the returns may seem less volatile during market fluctuations.
Risks of Small Cap Investing
It is worthwhile to know what you are getting yourself into with regard to risks because small cap investing offers exciting opportunities:
1. Higher Volatility
These are highly volatile small cap stocks that experience huge price swings, especially. Such volatility is typically hard to stomach for risk averse investors.
2. Information
Less analyst coverage or publicly available information of smaller companies often exists. Therefore, it becomes hard to do proper research on such stocks. Investors need to be cautious with analysis.
3. Market Risks
Small cap stocks do not evade the market risks involved in all equities. Some economic downturns tend to hit smaller firms more sharply; hence, their stock prices fall even more sharply.
Conclusion
The small cap effect stands out as one great opportunity for you if you are an investor seeking to beat the market average. You can therefore formulate a solid investment strategy with small cap value and quality equities taking advantage of such effects.
History dictates that small cap stocks have returned more reliably, especially when prudent investment decisions are taken, and the most volatile options are avoided. With a solid strategy, including robust value and quality screening, you can well be positioned to capture the small cap effect and gain above 99 percent of investors.