Small-Cap Rally Has Legs

When we're young and idealistic, we imagine if we will ever sell out. When I make it big, I recall myself saying, there are just three products I'll shill: Mountain Dew, Armor All, and Triumph sports cars. After all, I have my integrity to consider. Older and wiser, I now add one other: small-cap stocks.

What makes this especially difficult for an aging punk like me is that I work on a small-cap stock newsletter. Might not a purist construe a pitch for small caps as vaguely commercial, if not downright self-serving? Maybe a purist would, but then you know what, sometimes you've just got to get the word out.

You call that balance?
Market leaders are fine, but small caps, especially small-cap growth stocks, rocket out of recessions. Already, we are in a period of small-cap outperformance. Since the market turned south in April 2000, the S&P 500 is down 30% vs. a decline in the small-cap Russell 2000 of just 1%. Bear in mind, too, that periods of small-cap outperformance have historically exhibited extraordinary staying power.

Unfortunately, like many of you, the bear market did some strange things to my portfolio. I didn't sell a lot, mind you, but I did gradually stop buying (that is, outside of my 401(k), which is on autopilot). As a result, I woke up one day with too much cash (as if!) and way too much exposure to a few market gorillas.

As always, the first step was recognizing I had a problem. After all, I should have been fairly balanced. While I have a good chunk of my retirement assets in a variety of S&P 500-type (read: large-cap growth) index funds, I also have a decent allocation in broader, what are sometimes called, total market funds.

But the more I felt (and still feel) the recovery a comin', the more I wanted small-cap exposure.

Let's get small
I know what you're thinking: Your total market funds have you covered. Total Market, get it? Sometimes there's less in a name than meets the eye. In fact, there's not all that much difference between most total market funds and S&P index funds. And what little difference there is certainly does not give you exposure to small caps.

Here, I thought I was small, but I was tall!

Don't believe me? Check out the top 10 holdings of Vanguard's S&P 500 Index Fund: General Electric (NYSE: GE  ) , Microsoft (Nasdaq: MSFT  ) , Wal-Mart (NYSE: WMT  ) , ExxonMobil (NYSE: XOM  ) , Pfizer (NYSE: PFE  ) , Citigroup (NYSE: C  ) , Intel (Nasdaq: INTC  ) , American International Group (NYSE: AIG  ) , Johnson & Johnson (NYSE: JNJ  ) , and old IBM (NYSE: IBM  ) .

The top holdings for Vanguard's Total Market Fund? Precisely the same. And if you think it's a question of scale, you're only partly right. For the S&P 500, these 10 make up roughly 23% of the total fund. For the Total Market, they make up just over 18%. The fact is both funds are capitalization weighted, meaning you get much more exposure to the big boys and effectively none to the little. It's no wonder the two funds track so closely.

Little less talk, little more walk
Some time around January or February this year, this feeling of being under-invested and unbalanced washed over me like -- I don't know -- one of those things that wash over you. But how to get in -- and small --without doing something rash? I had some specific small caps in mind, but frankly I needed a stopgap until I was ready to start building my portfolio. Funds were an obvious choice, but you'd be surprised how difficult it is to get into a decent small-cap growth fund -- value maybe, but growth is a whole different ballgame.

Long story short, I opted for the iShares S&P 600 Index (IJT), trading at the time at about $65. Though it trades like a stock, this exchange traded fund (ETF) essentially tracks the price and yield performance of the S&P Small Cap 600/BARRA Growth Index. Buying and selling the fund is easy and -- because it's passively managed -- annual fees are reasonable.

The fund gives me instant exposure to builder NVR Inc. (NYSE: NVR  ) , Hi-fi legend Harmon International (NYSE: HAR  ) , my local favorite, Mid-Atlantic Medical (NYSE: MME  ) , and drug-maker Cephalon (Nasdaq: CEPH  ) -- all great stocks I've considered buying in their own right. What's more, the fund puts my money fully to work in small and very small growth companies. My next investment will likely be the sister fund, the iShares S&P 600 Value Index (IJS).

The low-lying fruit picked?
Believe me, it won't be easy raiding a fund that has treated me so well to invest in individual small stocks. But I have no concern that small-cap investing is a bad idea or that the latest small-cap renaissance is headed toward decline. Even if we're not headed for recovery, intuition tells me that, longer term, smaller companies are more adaptable and better poised for explosive growth than the handful of behemoths I hold in no less than five different funds.

For historical context, if not confirmation, Ibbotson Associates has the best numbers around. According to Ibbotson, since 1926, small-cap stocks have delivered average annual returns of 12.4% vs. 10.7% for large caps. And that's overall. When small caps out-perform, they seriously out-perform, and periodic cycles of outperformance are to be expected and typically last -- depending on whom you ask, from five to seven years to 10 years or more.

A late-2002 study by Moody, Aldrich & Sullivan goes one step further, identifying four distinct periods of small-cap outperformance (on average, 9.6% better than large caps) and within those, four subsets of periods of "ultra-performance" during which small caps outperformed by an average of 20%. The study draws some bold conclusions, most notably: We are three years into a period of "ultra-performance."

The small-cap secret is out
OK, the secret has been out for some time. I can't even say for sure that it ever was in. But it's out. While I can't confirm Moody, Aldrich & Sullivan's conclusions, I can say this: Much like Mountain Dew, Armor All, and Triumph Spitfires (OK, bad example), small caps work. At least they always have. If you don't have exposure to small caps, you probably want it. If you think you're getting it from broad market index funds or plain vanilla value or growth funds, you're probably not.

The Holy Grail is to cull the best small caps from a universe that is admittedly broader and more diverse than the S&P 500. But this takes time. Tom Gardner, among other Fool analysts, does a lot of the heavy lifting in his Motley Fool Hidden Gems. Barring that, or until you settle on your small-cap lineup, a small-cap index can be a cost-effective, easy way to beat inertia and get some quick small-cap exposure without taking on undue small-business risk.

Don't doubt that the small-cap road gets rocky from here. But if history serves, it's a ride you want to take, and you still have enough time.

Paul Elliott is the managing editor of Tom Gardner's Motley Fool Hidden Gems and owns IJT, but no individual stocks mentioned in this column. The Motley Fool is investors writingfor investors.

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