Why This Strategy Wins

Investing a portion of your portfolio in small-company stocks can boost your overall returns, providing just that extra bit of juice that will help you beat the market over the long term.

Some of the reasons are obvious. Intuitively, we know that if we're going to be fortunate enough to achieve Wal-Mart-type gains with any of our investments, they will come from smaller companies. If I'd been able to drop just $1,000 into Sam Walton's then-small retail chain after graduating from high school in 1977, it would have turned into nearly $1 million by now. And there's no shortage of such examples. Consider the following companies that went from small to large in just the past decade:

There is a motley assortment of industries represented in that list, from energy to software to pharmaceuticals. While large caps grab the big headlines, they're not the type of investment that will appreciate 1,300 times in value over the next 20 to 30 years, as Wal-Mart once did. Only small companies have that potential.

But let's consider some less obvious reasons why we should all try to "think small."

Wrong price tag
Let's look at two companies -- semiconductor giant Intel and little Middleby, which makes commercial ovens for restaurants.

A total of 40 analysts cover Intel, and thousands of experts dissect its every move in news stories, Internet blogs, and discussion boards. The Motley Fool's Intel discussion folder contains more than 50,000 posts, with some of the best analysis anywhere. Though its business is somewhat complicated, you'll find Intel experts on every street corner. Its stock, which trades about 70 million shares per day, may very well be over- or undervalued. But it's also fair to say that it is somewhere in the neighborhood of fairly valued. Or at least in the same city.

By contrast, Middleby draws a tiny handful of analysts. Weeks can pass before a news story about it crosses the wire. Very, very few people outside the company have a thorough understanding of the business. What are the chances that its stock price is correctly valued? It's possible, but on the other hand, the price could be so far from fair that it's not even in the same country.

When Tom Gardner first recommended Middleby for his Motley Fool Hidden Gems newsletter in November 2003, he thought the market was severely mispricing the stock by not recognizing the value of the company after CEO Selim Bassoul streamlined the business to focus solely on ovens. Tom was right, and the stock is up 650% since.

Be the cream
The next reason to like small caps dovetails nicely with the point above. We've seen why small companies are more likely to be mispriced than large ones. But mispricing goes in both directions, and that means a small-cap stock could be wildly under- or overvalued. You need to be able to separate the winners from the losers.

Because fewer analysts, institutions, and individual investors follow small companies, you're more likely to benefit from the knowledge that comes from solid, detailed research. After all, every stock transaction involves a buyer and seller. The person most likely to benefit is the one most knowledgeable about the company. With fewer brilliant minds looking at these companies -- Warren Buffett can't buy small caps -- you can be the cream that rises to the top.

Favorable research
Finally, there's solid evidence that, as a group, small caps tend to outperform large caps. In his book Investment Fables, professor Aswath Damodaran pulls together research pertaining to various investing strategies. Using data from Gene Fama and Ken French, Damodaran found that smaller stocks earned higher average annual returns than larger stocks of equivalent risk for the period from 1927 to 2001. When comparing the smallest subset of stocks with the largest, the difference is considerable: 20.0% versus 11.7% on a value-weighted basis, with an even greater difference on an equally weighted basis.

Of course, there were many periods when large caps outperformed small caps, as there will be in the future. But on average, small caps offer higher returns.

In sum
Those are some of the reasons I seek out small caps for a portion of my portfolio -- and why you should consider doing so as well. Unless you're an expert and have faith in what you're doing, they should not dominate your portfolio, since they carry more downside risk than stable, blue-chip companies. But reserving 10% to 20% of a well-rounded portfolio for these small guys can certainly pay off in the long term.

If you're interested in learning more about small caps, consider a free trial to Hidden Gems. Tom and his guests have achieved 59% average returns for their recommendations since the newsletter's inception, compared with 25% for like amounts invested in the S&P 500. Click here for more information.

This article was originally published on Feb. 25, 2005. It has been updated.

Rex Moore helps Tom and team dig for small caps. He owns shares of Qualcomm. Time Warner, Yahoo!, and Biogen are Motley Fool Stock Advisor picks. Wal-Mart and Intel are Inside Value selections. The Motley Fool is investors writing for investors.