Bill Miller, the well-known mutual fund manager at Legg Mason, recently called large-cap stocks a "once-in-a-lifetime opportunity." I've read reports from other investors and the Wall Street cognoscenti that large caps are the place to be.
Hogwash. Small-cap stocks still offer us the best chance at market-beating, if not market-smashing, returns from today. Here's why.
No. 1. Home-run swinging
Small-cap companies, those with a market cap of less than $2 billion, can sometimes carry volatile stocks that scare away investors, especially those afraid of short-term uncertainty. But that works in our favor. By embracing volatility, small-cap investors tread where others, and much of Wall Street, don't because they can't see past the next quarter's results.
But if we're to hit those home runs that Peter Lynch made famous in his book One Up on Wall Street, stocks that can make you three, four, five times your money or more, then we have to swing at well-positioned, high-potential small caps. Take a company like Marvel that grows from an obscure $200 million company into a media darling within seven years, only to be bought out by Disney for $4 billion.
Of course, small caps will also have flame-outs, too. So to keep your stomach from churning too much, it's good to balance your small caps with stable, global, less volatile large caps like Procter & Gamble (NYSE: PG) or Coca-Cola (NYSE: KO).
But if you're looking for the market's best stocks, then you need to be looking at small-cap stocks.
No. 2. Consistent outperformance
Small-cap stocks have a distinguished history of outperforming the general market. Over the trailing one-, three-, five-, and 10-year periods, small caps, as measured by the iShares Russell 2000 ETF (NYSE: IWM), have beaten the SPDR S&P 500 ETF (NYSE: SPY) by at least 1.5 percentage points a year. Furthermore, the S&P lost money during three of those periods (in the green for only the past year) while the Russell lost only once (and still smacked the SPDR).
The past 10 years may have been a lost decade for large caps (the S&P 500 is down 12% from the bubble days of 2000), but small-cap stocks are actually up 50%. Also, studies show that small-cap stocks have outperformed their large-cap cousins coming out of the past few recessions. So if history is to repeat itself, then over the next few years as we continue to crawl out of the Great Recession, you'll want at least part of your portfolio filled with high-quality small-cap stocks.
Some investors may think, though, that after a 15% run this year and an 85% increase since 2009 lows, small caps are past their prime and large-cap valuations are too attractive to pass up. As my colleague Matt Koppenheffer points out, some blue chip stocks are just "crazy cheap" in his eyes. Seeing a wide-moat industry leader like Microsoft (Nasdaq: MSFT), with its 40% operating profit margins and 20%-plus returns on capital, selling for less than 12 times free cash flow is enough to whet any investor's appetite.
But will Microsoft, with a $280 billion market capitalization, double your money over the next few years? I own Microsoft myself and expect a healthy return, but it's not likely to be a multibagger for me.
No. 3. "15x15" blue chip bargains
Which gets me to my third reason why I want you investing in small-cap stocks today: There are still bargains out there. Over at Motley Fool Hidden Gems, our small-cap investing service, my co-advisor Seth Jayson and I spend our days hunting for quality stocks. We're even investing $250,000 of the Fool's balance sheet into our favorite ideas. We wouldn't be doing this if we didn't think the right small caps offer great returns.
Using software from Capital IQ, a division of Standard & Poor's, I found more than 350 small-cap stocks on major U.S. exchanges with returns on capital greater than 15%. More than half of these sell for less than 15 times trailing earnings (I call that a 15x15 investment), including some you may recognize, like Domino's Pizza (NYSE: DPZ). One that caught my attention is Lancaster Colony (Nasdaq: LANC), the maker of Marzetti salad dressings and other branded foods. You might not recognize the company name, but its Marzetti brands may be sitting in your refrigerator right next to that milk carton.
Now this basic list is just a jumping-off point to start our research, but my point is that there are still plenty of small-cap stocks out there for you to consider for your portfolio. Don't let this year's outperformance scare you away from well-run, financially stout, growing small-cap companies. These are the stocks that over time, for patient investors willing to roll with the ups and downs, can deliver market-smashing returns.
If you want to learn more, I invite you to take a 30-day free trial of our Hidden Gems service. Click here to get started.
