There is a reason I have part of my portfolio invested in small companies. Many reasons, actually, and I'll share a few of them with you.
Some are obvious. Intuitively, we know that if we're going to be fortunate enough to achieve Southwest Airlines-type
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 and FARO Technologies
A total of 39 analysts cover Intel, and thousands of experts dissect its every move in news stories, Internet 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 70 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, FARO draws exactly two 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 also could be so far from fair that it's not even in the same country.
When Tom Gardner first recommended FARO for his Motley Fool Hidden Gems newsletter in October 2003, he felt the market was severely mispricing the stock by not recognizing the value of the company after a cyclical downturn in manufacturing and business spending, accompanied by investor impatience. Tom was right, and the stock price is up more than 150% since.
Be the cream
This 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 undervalued 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 most likely to benefit is the one most knowledgeable about the company! Because they must invest huge sums to benefit their portfolios, masters like Warren Buffett simply can't buy small caps. With fewer brilliant minds looking at these companies, you and I can be the cream that rises to the top.
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 period 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 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.
Those are some of the reasons I seek out small caps for a portion of my portfolio -- and why you should consider doing so also. Unless you're an expert and have faith in what you're doing, they should not dominate your portfolio. They do 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 to 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 31% average returns for their recommendations, vs. 8% 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 loving baseball season and owns no stocks mentioned in this story. Coca-Cola is a Motley Fool Inside Value recommendation. The Motley Fool isinvestors writing for investors.