Will Small Stocks Keep Shining?

There's a simple maxim in investing: "The trend is your friend." For those who've taken on the greater risk of investing in shares of small companies, a decade of outperformance compared to larger-company stocks has been friendly indeed.

But like houseguests who worry that they've overstayed their welcome, small-cap investors have gotten nervous that those years of crushing better-known, more popular big stocks are coming to an end. That raises a simple question: Is it time to get out of small-cap stocks, or are there places you can invest that should thrive no matter what happens?

Looking at history
This month's new issue of Rule Your Retirement takes a close look at choosing between small-cap and large-cap stocks right now. Everyone knows about the lost decade for stocks, in which major market indexes like the Dow Jones Industrials (INDEX: ^DJI) have essentially gone nowhere. But when you look at broad measures of small-cap stocks, you can see that the 2000s weren't a lost decade at all. The Russell 2000 index of small caps actually rose 6.5% annually over the past 10 years, beating the S&P 500's average annual return by nearly 4 percentage points. A 6.5% return may not be what stock investors hope for, but it's a far cry from making nothing on your money.

If you think that level of outperformance is particularly special, think again. Over the past 85 years, through good times and bad, small caps have beaten large caps by more than 2 percentage points. Put another way: $1 invested in small caps back in 1926 would now be worth almost $16,500, versus just over $3,000 for $1 invested in large caps.

Ready for a fall
This past month, though, investors have remembered the other side of the risk/reward equation. The Russell 2000 was down almost 9% in August, compared to less than a 6% decline for the S&P 500 and just over 4% for the megacap-heavy Dow. Several promising small caps -- including Star Scientific (Nasdaq: CIGX  ) , Solazyme (Nasdaq: SZYM  ) , and Glu Mobile (Nasdaq: GLUU  ) -- saw losses in the neighborhood of 40% in just one month. By contrast, none of the members of the large-cap S&P 500 lost close to 40%.

Small-cap stocks are definitely more volatile than their larger peers. That's because their prospects are always less certain; while a bad spell can put a crimp in a big company's financials for a while, it takes a lot more to threaten its very survival. By contrast, small caps face potentially catastrophic challenges all the time.

What's next?
In general, returns for small caps and large caps have moved in cycles. Given the huge interest in dividend-paying stocks lately, large caps could well have their time in the sun for the foreseeable future. Big companies are much more likely to pay healthy dividends than small ones, since growing businesses typically need to plow as much of their income as possible back into expansion rather than returning it to shareholders.

However, as Rule Your Retirement's interview with several Fool analysts describes in more detail, sticking with companies that have strong fundamentals is a winning strategy whether you're talking about large caps or small caps. For instance, some of the mutual funds that Fool fund expert Amanda Kish follows in the small-cap realm have taken different paths toward trying to make the most of the current environment, including stocks ranging from Unisys and regional bank First Niagara Financial (Nasdaq: FNFG  ) to small miners Endeavour Silver (NYSE: EXK  ) and US Gold (NYSE: UXG  ) .

Learn more
There's a whole lot more in the newest edition of Rule Your Retirement, including several stock recommendations from other Fool newsletter services. With a free 30-day trial subscription, you can get full access to the entire discussion along with a host of other valuable resources.

In the end, it's not very important whether the broad small-cap market indexes can keep outperforming their large-cap counterparts. As long as the small-cap and large-cap stocks you pick do well, you'll be prepared to stay in the financial sun for years to come.

It's easy to see everything Rule Your Retirement has to offer. Just take a sneak peek on us; a 30-day free trial gives you no obligation to subscribe, so click here and get started today.

Fool contributor Dan Caplinger makes hay while the sun is shining. You can follow him on Twitter here. He doesn't own shares of the stocks mentioned in this article. The Motley Fool owns shares of Solazyme. 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 Fool's disclosure policy works rain or shine.

Read/Post Comments (8) | Recommend This Article (12)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 03, 2011, at 12:41 AM, PatientInvstr wrote:

    No offense to you, as I can probably imagine this article took many hours of work, but I feel like it was a waste of my time to read it. I don't mean to bash, and mean no offense to the author as it was a very well written and thought out, as well as probably informative for some. It just was the basics, small caps are risky, large caps arn't, large caps have dividends which help protect their volatility, etc, etc. I also worry the stocks mentioned could possibly be mentioned for reasons unethical. But that is merely an educated guess and not a statement or a fact.

  • Report this Comment On September 04, 2011, at 11:40 AM, AaronRogers wrote:

    To the writers credit if you read what Motley Fool wants as a blog or post this fits the bill. I agree with your thought that this article for such a well respected publication is way to broad, simple and lacks truly substantive work and education. However, its Motley's form that is the issue. I blogged for my first time (surprising got 20 rec's and was never even posted to anything) but Fool responded by saying I need links (which I wasn't sure how to do) and it should be short etc...

    So in order for the writer to be printed it had to be this way.

    Motley needs to change/allow more substantive material to be printed.

  • Report this Comment On September 04, 2011, at 8:34 PM, TMFGalagan wrote:

    @PatientInvstr -

    Thanks for your comments. It's always a tough balancing act to try to write something that is useful and informative for investors of all skill levels. I think you'll find though that overall, when you look at the range of different articles you'll find on Fool.com, you'll get a good mix of more deep-diving articles that you'll fully appreciate along with some other basic articles that may be less sophisticated than where you are with your investing.

    best,

    dan (TMF Galagan)

  • Report this Comment On September 05, 2011, at 12:51 AM, StockNewb wrote:

    hey Dan

    loved the article albeit it is truely a basic one, but where else should we send beginners other then here?

    btw make more youtube videos guys ;)

    StockNewb

  • Report this Comment On September 05, 2011, at 9:20 AM, TMFGalagan wrote:

    @StockNewb - I'll pass on the video comment!

    And on basics for small-caps, I'd start with this Sean Williams article:

    http://www.fool.com/investing/small-cap/2011/09/02/small-cap...

    and then work your way through Sean's "10 Small Caps to Rule Them All" series:

    http://www.fool.com/investing/small-cap/2011/05/12/10-small-...

    best,

    dan (TMF Galagan)

  • Report this Comment On September 05, 2011, at 11:16 AM, pastreet wrote:

    I've been looking at small, locally based companies with characteristics that move them contrary to prevailing economics. One of my favorite recent stocks added to my watch list has been HOOK, Craft Brewers Alliance. Based out of Portland, they are a regional brewery that has been performing well in recent years, and seem to offer the possibility of decent growth coupled with a large INBEV interest, which could develop into a takeover bid.

    Pat

    www.compoundingreturns.com

  • Report this Comment On September 05, 2011, at 5:10 PM, xetn wrote:

    "Put another way: $1 invested in small caps back in 1926 would now be worth almost $16,500, versus just over $3,000 for $1 invested in large caps."

    I am sick to death of hearing this kind of comparison. No body would ever live to see these returns. Even if someone lived, they would have been wiped out in 1929-1933. Its like saying if I had purchased 4000 acres in the 1800s that would become Orange County, Ca, I would now be a Trillion-aire.

  • Report this Comment On September 06, 2011, at 12:53 AM, lowmaple wrote:

    xetn: your point is correct of course but this comparisson shows even after huge plunges if you could hang on, youcould have made hese gains. Of course those that went too far out on a limb crashed.

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