Last year was a bumpy one for small companies. The Russell 2000 small-cap index was off 11% from its high at one point and then climbed nearly 20%. After the dust had settled, it finished 2005 about 5% in the black.
That's quite a ride, eh? But believe it or not, this volatility is not a negative; instead, it's one of the big advantages of investing in such companies, one we embrace in our Motley Fool Hidden Gems small-cap service. Let's talk about why volatility is our friend, and explore some reasons why you should have a portion of your portfolio in smaller companies.
Let's get small
The Russell 2000 consists of the 2,000 smallest companies in a much broader total market index, and is the top small-cap benchmark in the U.S. It counts AmylinPharmaceutical (Nasdaq: AMLN ) , Intuitive Surgical (Nasdaq: ISRG ) , and CimarexEnergy (NYSE: XEC ) among its top holdings. These companies have market caps as high as $4.8 billion.
However, we define small caps as businesses with a market capitalization of $200 million to about $2 billion. By comparison, look how big some of the giants are: eBay (Nasdaq: EBAY ) is worth about $60 billion, and Microsoft (Nasdaq: MSFT ) , Wal-Mart (NYSE: WMT ) , and General Electric (NYSE: GE ) are in the $200 billion to $300 billion range. Each of these American icons, solid as they are, simply do not have the potential to become a classic Peter Lynch 10-bagger over the next five years. Their hypergrowth days are behind them.
Our challenge, then, is to find small caps with a sturdy capital structure, top-flight and non-promotional executives, prospects for years of cash flow growth, and an inefficiently low price tag on their business. Find enough of those, and the multibaggers will come.
Thin and rich
What's more, we're interested in companies that are too small and too thinly traded to attract much Wall Street coverage. That makes them underfollowed and increases the chances that they're undervalued.
Why? The less activity in a marketplace or auction house, the higher the probability of pricing inefficiencies. When there is only one bidder for an electric dog polisher, the chances for mispricing are infinitely higher than when thousands of investors bid every day on the present price of IBM or Pfizer stock. That small-cap inefficiency provides opportunity for private investors.
This chance for pricing inefficiency is even higher because the brightest investment minds (think Buffett) are priced out of small caps. Because they invest with billions of dollars, their professional success attracts more money, forcing them farther out of the small-cap arena. They simply can't buy enough shares of a small-cap stock to make any meaningful difference to their overall investment returns, so they disregard these companies.
What's left for small investors? Less pricing efficiency and more opportunity for success among small-cap stocks. Fewer investors in our small-cap territory, fewer geniuses, and fewer bids in a given week or month.
Of course, these stocks -- because they are underfollowed -- are subject to the volatility we mentioned earlier. Small-cap investors know that a $500 million company can see its price rise or fall 25% in a single month ... without meaningful news on the operations of the business. That short-term rise or fall may faze some investors. So, if this kind of volatility will drive you crazy, don't put your money here; there are better places for it.
Small capping it off
Because of this volatility, we recommend that -- when tracking down prospects with us -- you (1) diversify through a total market index fund, (2) remain focused on a three- to five-year time horizon, and (3) not risk so much of your investable assets that radical price changes in the short term put your emotions into play.
We're proud that our Hidden Gems recommendations have racked up 36% average gains -- vs. 14% for the same amounts invested in the S&P 500 -- since the service launched in 2003. You can view our favorite small-cap companies now by taking a free trial, with no obligation to subscribe.
In the meantime, start to think small.
This article was first published on April 7, 2004. It has been updated.
Tom Gardner is co-founder of The Motley Fool and an all-around good guy. He owns shares of Pfizer and Microsoft. Rex Moore is co-founder of the Sea Monkey Rescue Group and an all-around great guy. He owns shares of eBay and Microsoft. eBay is a Stock Advisor pick; Microsoft and Pfizer are recommendations of Inside Value; Intuitive Surgical is a Rule Breakers selection. The Motley Fool is investors writingfor investors.