Smaller-Company Stocks Offer Lots of Room to Grow

Huge, profitable powerhouses were once smaller-company stocks.

Apr 10, 2014 at 3:39PM

Exchange-traded funds offer a convenient way to invest in sectors or niches that interest you. If you'd like to add some smaller-company stocks to your portfolio but don't have the time or expertise to hand-pick a few, the Schwab Fundamental U.S. Small Company ETF (NYSEMKT: FNDA) could save you a lot of trouble. Instead of trying to figure out which stocks will perform best, you can use this ETF to invest in lots of them simultaneously.

The basics
ETFs often sport lower expense ratios than their mutual fund cousins. This ETF, focused on smaller-company stocks, sports a relatively low expense ratio -- an annual fee -- of 0.32%. The fund is fairly small, too, so if you're thinking of buying, beware of possible large spreads between its bid and ask prices. Consider using a limit order if you want to buy in.

This smaller-company-stock ETF is too young to have a sufficient track record to assess. As with most investments, of course, we can't expect outstanding performances in every quarter or year. Investors with conviction need to wait for their holdings to deliver.

Why smaller-company stocks?
It's smart to include smaller-company stocks in your portfolio, as the best of these companies can grow rapidly and eventually become large caps. This smaller-company stocks ETF has a particular angle, too, tracking the "RAFI" fundamental indexing system developed by Rob Arnott that weights holdings by fundamental size measures, not market cap. It's worth noting that though this ETF is focused on smaller companies, some of its components are more mid-caps than small-caps.

Lots of smaller-company stocks had strong performances over the past year. AK Steel Holding Corporation (NYSE:AKS), for example, surged 140%. Management is worried about competition from imported steel (mainly from China) and possible overcapacity, but also pleased with demand from a recovering auto industry. AK Steel returned to profitability in its fourth quarter but recently issued guidance that it will dip back into the red in its next quarter. The reasons are short-term in nature, though, and prices are rising. Bears don't like its heavy unionization and pension obligations, among other things.

Brocade Communications Systems (NASDAQ:BRCD) popped 80%. It, too, has warned of pullbacks in its business, though its last quarter featured earnings that surpassed expectations (albeit along with a 4% drop in revenue over year-ago levels). The networking storage specialist has been moving into cloud computing and Big Data, both areas with great growth potential.

Trinity Industries (NYSE:TRN) gained 66%. The company gets most of its earnings from making rail cars and stands to see more business due to new regulations calling for safer railcars. The company's main problem, arguably, is how it will keep up with demand, as its order backlog jumped 52% in the last quarter over year-earlier levels, and stood at more than 40,000 railcars, worth more than $5 billion. That same quarter featured revenue and earnings surging by 24% and 58%, respectively. Bulls like Trinity Industries' diversification, as it is also involved in railcar leasing, barge manufacturing, construction services, and more. It's even a major wind tower maker.

Other smaller-company stocks didn't do quite as well over the last year, but still far better than most stocks. Chicago Bridge & Iron Company (NYSE:CBI), for instance, advanced some 46%. It offers construction and engineering services to the energy and natural resources sectors, working on projects related to the water, hydrocarbon, and nuclear industries. It recently hit a 52-week high and it has been racking up lots of contracts lately. Its fourth quarter featured revenue nearly doubling over the year-earlier quarter, and management noted that, "With record high new awards and revenue, 2013 was without a doubt the strongest year in the company's 125 year history." The company bought Shaw Group in 2012, a company known for constructing nuclear-related buildings.

The big picture
If you're interested in adding some smaller-company stocks to your portfolio, consider doing so via an ETF. A well-chosen ETF can grant you instant diversification across any industry or group of companies -- and make investing in and profiting from it that much easier.

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Selena Maranjian, whom you can follow on Twitter, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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