Where Small Investors Have a Big Edge

Small investors face a lot of disadvantages when it comes to investing. But there's one area where many of those handicaps turn into benefits for the average investor: small-cap stocks.

Face it -- if you want to focus on popular large-cap stocks, you'd have to devote yourself full-time to stock analysis just to keep up with the Wall Street juggernaut. Consider just how many professional analysts track the household names you know so well:

Stock

Market Cap

Number of Analysts

Apple (Nasdaq: AAPL  )

$159 billion

30

Genentech (NYSE: DNA  )

$104 billion

24

Oracle (Nasdaq: ORCL  )

$119 billion

24

Wells Fargo (NYSE: WFC  )

$99 billion

21

Intel (Nasdaq: INTC  )

$136 billion

34

Caterpillar (NYSE: CAT  )

$43 billion

22

Source: Yahoo! Finance.

When you're up against institutional investors who are armed with the information these professional analysts dig up every day, it's a lot harder to find an edge. Even though Wall Street analysts have biases that you may be able to use to your advantage, the odds are pretty slim that you'll discover something the rest of the investing world doesn't already know about.

The path less traveled
In contrast, a universe of thousands of small companies out there get nearly no attention from professional investors. Even many companies with strong performance records, such as Sadia (NYSE: SDA  ) , have few or no analysts covering them. Although many of these companies will languish in obscurity for decades, you can expect that a select few will be the household names of tomorrow.

Recently, fellow Fool Ilan Moscovitz did an interesting study comparing small-cap and large-cap returns. Looking at both beaten-down stocks and highfliers, he found that small companies outperformed their larger brethren on average across the board. His research confirms other findings that show how small caps have outperformed larger companies over the long haul.

Leaving money on the table
Given the academic support for small-cap outperformance, you might wonder why Wall Street doesn't pay more attention to this lucrative area of the market. The answer has to do with the massive amounts of money institutional investors manage.

Billionaire investor Warren Buffett once said that he could generate 50% returns as long as he only had $1 million to invest. When you're managing billions, it gets difficult to invest in small companies -- either you have to buy such a small stake that it won't make much difference to your overall portfolio, or you risk moving the market when you purchase large blocks of shares. Consider how many successful small-cap mutual funds, such as Baron Small Cap (BSCFX) and Third Avenue Small-Cap Value (TASCX), have closed their doors to new investors at some point when their assets grew too quickly. When funds that focus on small-cap stocks run out of good ideas, taking in new money is counterproductive.

In contrast, when you have a relatively small amount of investment capital, you can invest large portions of your portfolio in even the smallest stocks without worrying about taking too big a stake in any one company. Rather than spreading out your investments across dozens or even hundreds of small companies, you can keep a tightly concentrated portfolio that includes only your best ideas, helping you maximize your overall returns.

Because Wall Street firms with high net-worth clients can't capitalize on small caps as efficiently as we small investors can, they mostly ignore them. The resulting vacuum of information about these little-followed companies spells opportunity for smart individual investors who are willing to do their own legwork.

So if you want to find investment ideas where you can truly have an advantage over the Wall Street crowd, take a closer look at small-cap stocks. If you can separate the truly extraordinary companies of tomorrow from the also-rans, you'll find the returns are well worth the effort.

More on making the most of small-cap investing:

Want to learn how to discover tomorrow's great companies before the Wall Street crowd finds them? Tune in to our Motley Fool Hidden Gems newsletter. Each month, we find promising stocks with great business models and see if they have what it takes to be the stars of the future. A free 30-day guest pass gives you full access to everything we have to offer.

Fool contributor Dan Caplinger has gotten his feet wet with small caps, but he's only getting started. He doesn't own shares of the companies mentioned in this article. Sadia is a Motley Fool Hidden Gems selection. Intel is an Inside Value pick, and Apple is a Stock Advisor recommendation. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy covers everyone, large or small.


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