Why This Strategy Wins

There is a reason I have part of my portfolio invested in small companies. Many reasons, actually, and I'd like to share a few of them with you today.

Some are obvious. Intuitively, we know that if we're going to be fortunate enough to achieve Wal-Mart-type (NYSE: WMT) gains with any of our investments, it's more likely to happen with a smaller company. 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 more than $1 million by now. So, while it's fun to read that ExxonMobil (NYSE: XOM) moved back ahead of General Electric (NYSE: GE) for the right to be called the world's largest company, it's safe to say that neither will appreciate 1,100 times in value over the next 20 to 30 years, as Wal-Mart once did. Only small companies have that kind of 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 (Nasdaq: INTC) and little Middleby (Nasdaq: MIDD), which makes ovens for restaurants such as McDonald's (NYSE: MCD) and Pizza Hut.

Three dozen analysts cover Intel, and thousands of experts dissect its every move in news stories, blogs, and discussion boards. The Motley Fool's Intel discussion folder contains more than 50,000 posts, offering 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 65 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 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 the price could also 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 felt 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 price is up 550% 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, meaning 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 more 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 is 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 years from 1927-2001. When comparing the smallest subset of stocks to the largest, the difference is considerable: 20% vs. 11.74% 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.

An interesting side note: Damodaran also cites research showing that the fewer analysts covering a company, the higher the returns tend to be -- even after adjusting for the fact that smaller firms draw less analyst coverage than larger ones.

In sum
So 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. 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, we're offering a free trial of Hidden Gems. Tom and his analysts have been actively seeking out small, mispriced companies since the newsletter's inception in July 2003. Thus far, they've achieved 28% average returns for their recommendations, versus 11% for money similarly invested in the S&P 500. Try it for free for 30 days. If it's not to your liking, it won't cost you a dime.

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

Rex Moore is brought to you by the letter M, and owns no stocks mentioned in this story. Wal-Mart and Intel are Inside Value recommendations. Middleby is a Hidden Gems pick. The Motley Fool is investors writing for investors.