Financial pundits are fast to proclaim the end of the great small-cap run. They say the hot money is already there and that small caps can't keep outperforming large caps as they've done for the past five-plus years.
Who's "they"? The Wall Street Journal. Forbes. The guys at Morningstar. Even some of my good buddies at Fool.com are telling you now's the time to buy mega caps.
Mega caps are just so darn cheap, they say. And that's true. Giants such as Microsoft (NASDAQ:MSFT), Qualcomm (NASDAQ:QCOM), Apple (NASDAQ:AAPL), MittalSteel (NYSE:MT), Aetna (NYSE:AET), Cemex (NYSE:CX), and Sprint Nextel (NYSE:S) are all trading at P/E ratios more than 10% below their historical averages.
Indeed, these data are compelling.
And yet ...
Here's what the large-cap crowd isn't telling you:
- Individual small-cap stocks offer the market's best returns.
- Small-cap value stocks have outperformed large-cap value stocks since 1927, according to Fama and French data.
- They were warning you about the small-cap apocalypse two years ago -- and yet small caps have gone right on outperforming.
Get smart with small caps
This is not to say that you should just go blindly throwing money at the small-cap Russell 2000 index. Nor can I guarantee that small caps as a sector will best large caps next month, next year, or even over the next five years.
No, this is all very much long-term stuff. But if you keep a long time horizon, your portfolio will do better by including carefully selected small caps.
That's because the best small caps should continue to do better than the best large caps since they're small (obviously) and can increase in size many times over. Even better, small caps are underfollowed by Wall Street -- giving individual investors like you and me the opportunity to take advantage of gross pricing inefficiencies.
So, no, you shouldn't be shorting small caps right now -- or, for that matter, making reactionary decisions based on short-term macroeconomic calls. Instead, keep hunting for the very best small companies, and keep adding new money to your portfolio on a regular basis. Those are two keys to long-term outperformance.
The Foolish conclusion
Our goal at Motley Fool Hidden Gems is to help investors find superior small caps. To do so, we seek great companies in out-of-favor industries that have superior management teams with significant ownership stakes, strong balance sheets, and dominant operators in profitable niches.
If you'd like to join the hunt for superior small caps at Hidden Gems free for a month, click here. There is no obligation to subscribe.
Tim Hanson does not own shares of any company mentioned in this article. Microsoft and Mittal Steel are Inside Value recommendations. No Fool is too cool for disclosure.
