Why You Need Small Caps Right Now

Why should you invest in small caps -- traditionally viewed as the riskiest class of stocks -- when the sky has been falling on all stocks?

The short answer: Because you can't afford not to. The long answer? Well, that will take a bit longer to spell out.

You think you know small caps …
In The Only Three Questions That Count, Ken Fisher challenges the reader by asking, "What do you believe that is actually false?"

For example, are small-cap stocks riskier than large-cap stocks? You may answer an emphatic, "Of course!"

In fact, the correct answer is: It depends.

Depends on what?
For one, it depends on the type of small caps and large caps being discussed.

Plenty of large caps were cut in half last year. In fact, here's what the conventional wisdom -- that big, entrenched companies will protect you amid market mayhem -- got you in 2008.

Market cap figures in billions. Data from Capital IQ, a division of Standard & Poor's.

It's true that I cherry-picked the list above, but it doesn't much matter -- I excluded financial companies like Citigroup (NYSE:C) and Bank of America (NYSE:BAC), which were crushed last year. (Indeed, the large-cap-laden S&P 500 fared worse last year than the small-cap Russell 2000 bogey.)

The list above includes mostly household names that undoubtedly will be around for decades to come. However, companies with tens of thousands of employees and vast operational bases can sometimes find it hard to overcome their inertia and adapt quickly to abrupt economic changes.

In other words, size becomes a liability. Small-cap companies -- at least the good ones -- can maneuver faster than larger competitors. I will take an agile small cap over a lethargic large cap any day -- especially near a market bottom.

Make no mistake
I am not calling a market bottom -- far from it. I do believe, however, that we are closer to the end of the downturn than the beginning. This takes me to the second important factor in assessing the relative risk of small caps -- where we are in the economic cycle.

A recent article in The Wall Street Journal made the case that "small caps [are] seen leading a rebound" when the market ultimately recovers. One bit of short-term evidence the Journal cited was that during the five-week rally from Nov. 20, 2008, to Jan. 2, 2009, small caps outperformed large caps 31% to 20%.

Fund manager Nancy Tooke noted that small caps have advanced as much as 50% in the first 12 months of a recovery. And fellow Fool Ilan Moscovitz ran the numbers of prior U.S. recessions and found that small caps outperform -- by a significant margin -- coming out of economic downturns. If you agree that the worst of the current downturn is behind us, it may be time for you to take another look at some overlooked and disregarded small-cap names.

A little flavor
One of our favorite small caps at Motley Fool Hidden Gems is Buffalo Wild Wings (NASDAQ:BWLD), which has jumped more than 40% over the past two months after delivering strong year-end results. What investors believed about the company -- that a small restaurant chain would fare terribly because consumers are penny-pinching -- turned out to be false.

The news came as no surprise to us, and I said as much in an article earlier this year. When small companies possess sound balance sheets, strong management, operational efficiency, and advantages over competitors, you remain calm when the market unfairly punishes the stock.

The final piece of the puzzle
Congratulations, you've made it to the final piece of the small-cap investing puzzle -- your time horizon.

Even though small caps may be poised to pop out of a recovery, they are not for short-timers. At Hidden Gems, our brand of small-cap investing is not for those looking to make a quick buck or those who cannot stomach severe volatility. If you need cash within five years, in fact, you should probably stop reading and go research CDs, money markets, or bond fund prospectuses.

But for those looking beyond five years, having a chunk of your portfolio in small-caps is a wise move. Indeed, one of the greatest benefits of small caps is that they have more room to grow -- but growth doesn't happen overnight. It takes years to play out. You wouldn't want to get acquainted with a fantastic company and have to sell your position to cover the down payment on your house … just as the investment thesis comes to fruition.

What do you believe?
Let's quickly recap:

1. The conventional wisdom that small caps are riskier was turned on its head last year, when large caps led the market slide.
2. Small caps have historically been the best stocks to own coming out of recessions.
3. Because they can be volatile, and because their growth stories will play out over years and not quarters, you must have a time horizon of at least five years -- and preferably longer.

I hope those are good enough reasons to start looking at small caps today. If you're thinking of adding new money to this market and need a few ideas, we can help.

We're happy to be in the beginning stages of building our real-money Hidden Gems portfolio, in which we'll be putting the Fool's money behind our very best small-cap ideas. If you still believe small caps are always riskier than large caps, we have a market-beating track record and a stable of companies to prove you wrong. Try us out free for 30 days -- I'm confident that we'll have you singing the praises of small caps in no time.

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Keith Beverly does not own share in any company mentioned. Google is a Motley Fool Rule Breakers recommendation. Apple and UnitedHealth are Stock Advisor picks; UnitedHealth is also an Inside Value pick. The Motley Fool owns shares of Buffalo Wild Wings and UnitedHealth and has a disclosure policy.