The Next Stocks You Should Buy

"Buy a small-cap stock."

I just wrote myself this simple note. See, lately I've been on a streak of buying large-cap stocks.

I'm probably not alone
The lion's share of mutual fund assets are tied up in large companies. In the list of the largest U.S. mutual funds, there's not a single small-cap-focused fund in the bunch. What's more, the S&P 500-tracking SPDRs exchange-traded fund took in $4.8 billion in July -- the biggest inflow of any ETF.

And while institutions account for a fair chunk of that inflow, the overall numbers are more startling. All told, SPDRs has more than $70 billion in assets; its small-cap cousin, the iShares Russell 2000 Index, has about $11 billion.

On asset classes and tautologies
Large-cap companies are widely followed, popular, and extremely newsworthy. And while it might seem obvious, they are also widely owned.

The big money follows the big stocks. I'm certainly not big money, but you can call my recent large-cap buying frenzy a flight to "safety" in a shaky market, or you can chalk it up to buying undervalued stocks. I prefer to think the latter.

Either way, the fact remains: Investors probably have enough large-cap exposure already. With so many dollars tied up in large-cap mutual funds or S&P trackers like the SPDRs, we already have significant stakes in big names like blue-chip big boys Bank of America (NYSE: BAC  ) , Coca-Cola (NYSE: KO  ) , and Google (Nasdaq: GOOG  ) .

Which is why I reminded myself to buy a small-cap stock.

Look, I'm a firm believer that large caps should be at the foundation of every equity portfolio. But if you're like me, you have a long-term time horizon (15-plus years), and capital appreciation is your primary investment objective, you need small-cap stocks. There are no two ways about it.

Do it. DO it.
For starters, unless you've made a concentrated effort to gain small-cap exposure in your portfolio, you may well be underallocated in this asset class. And that's a mistake: Small-cap stocks give investors the best chance at outperforming the market over the long haul. NYU professor Aswath Damodaran found that from 1927 to 2001, the smallest companies outperformed the largest ones with a 20% annual return versus 12% on a value-weighted basis. Many of the most successful small caps were:

  • Underfollowed on Wall Street.
  • Financially strong.
  • Well managed.
  • Dominant in their market niche.

These were traits that the likes of Dell (Nasdaq: DELL  ) and Southwest Airlines (NYSE: LUV  ) shared early on, and they turned out to be some of the best stocks of our generation -- even though recent years have been less spectacular for both. Thirty years from now, it's very possible that we'll look back at some of today's small caps and wonder how we missed those massive opportunities.

Great companies are out there
Back in March 2007, I wrote about Sun Hydraulics. At the time, it was a $250 million purveyor of screw-in hydraulic cartridge valves and manifolds for things like bulldozers (yawn!) that I thought shared similar traits to those three great aforementioned companies.

Fast-forward 18 months, and Sun Hydraulics shares have risen 74%, while the S&P lost 10%. Such a quick validation of an investment thesis doesn't always happen, but it's sure nice when it does.

I'm happy with Sun's performance -- I still own shares -- but owning one or two small caps does not a diversified portfolio make.

Making it happen
There are various ways to add small-cap exposure, among them ETFs and mutual funds. Both are perfectly valid options, but they have their drawbacks. For one, the more popular funds, such as Vanguard Explorer (VEXPX), have so much money under management that they must spread out their bets over 1,000 or more stocks (1,154 in Explorer's case), lest they take an ownership stake in the company or drive up the share price.

That's problematic for investors, because it waters down the growth potential of small caps. Sure, DENTSPLY International (Nasdaq: XRAY  ) and St. Mary Land & Exploration (NYSE: SM  ) may be great stocks, but since they make up only 0.44% and 0.58% of Explorer's portfolio, respectively, any outperformance won't make a huge difference to the fund.

An alternative is to handpick your own small caps. I know what you're thinking: "Aren't small caps risky?" Just as with any stock, yes, they can be. For my money, though, I'd much rather back a small company with a strong management team and a rock-solid balance sheet than a "safer" large company with newly appointed management and hard-to-understand financial statements.

Convinced yet?
Not only are small caps the best long-term performers, but they're also the best stocks to come out of bear markets. So if your portfolio could use a bit more growth potential, the next stocks you buy should be:

  • Small.
  • Underfollowed.
  • Financially strong.
  • Well managed.
  • Dominant in their market niche.

These are precisely the types of companies our Motley Fool Hidden Gems team looks for, and over the past five years, their picks have outperformed the S&P 500 by more than 21 percentage points on average. If you'd like to learn more about how small caps can help fuel your portfolio's growth, a free 30-day trial to Hidden Gems is yours by clicking here.

This article was originally published on August 1, 2008. It has been updated.

Todd Wenning hopes you've enjoyed your summer. He owns shares of Sun Hydraulics but of no other company mentioned. Sun Hydraulics is a Motley Fool Hidden Gems pick. Bank of America is an Income Investor recommendation. Coca-Cola and Dell are Inside Value picks. Google is a Rule Breakers recommendation. Vanguard Explorer is a Champion Funds selection. The Fool owns shares of SPDRs. The Fool's disclosure policy is brought to you by the number 3.


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