"The smaller they are, the harder they fall."
That's a line that graced the front page of The Wall Street Journal's "Money & Investing" section the other day. It refers to the small-cap slide that's afflicted the market since mid-May.
The Journal is spot-on: Small-cap stocks are among the riskiest in the market. That said, tiny companies also offer the market's very best rewards.
Ignore the news
If you're like us, then you're sick of people like us. That is to say: You're sick of media folks who earn a living taking the market's temperature on a day-to-day basis. The market is irrational on a day-to-day basis, and its machinations matter not.
Or as master fund manager (and the agriculturally inclined) Ron Muhlenkamp is putting it so eloquently on his website these days, "Whether stocks run up or down 30 points today is no more important than whether or not we get 1/2 inch of rain."
A culture of fear
Yet it's worthwhile to take a step back and understand why small caps are getting smacked: fear. Fear of rising interest rates; fear of energy uncertainty; fear of the unknown.
Unlike the market's big fish, small caps tend to be lesser-known commodities. They're not covered by as many professional analysts, their management has not been as thoroughly vetted, they haven't been through as many business cycles, and they're more difficult for professional money managers (with lots of cash to invest) to move in and out of quickly.
So they're being sold off -- indiscriminately, in many cases.
But as the $580 million company American States Water (NYSE:AWR) CEO Robert Sprowls told The Wall Street Journal, "This [small-cap sell-off] isn't company-specific, I'm pretty certain of that."
In other words, small caps are being sold off as an asset class even though the futures of many small companies remain bright. Those falling prices create opportunities for smart investors who follow small caps closely.
The traits of great companies
Consider, for example, the traits that many financial pundits are imploring you to seek out in large caps these days:
- Reasonable price.
- Strong balance sheet.
- Established brands that can withstand an economic slowdown.
- Steady returns on equity and assets.
You'll find a number of great, large companies that possess these characteristics, including General Mills (NYSE:GIS), Abbott Laboratories (NYSE:ABT), PepsiCo (NYSE:PEP), and Microsoft (NASDAQ:MSFT). But with market caps of $18 billion, $65 billion, $99 billion, and $230 billion, respectively, you'll also find that these companies' years of great growth are behind them.
Two great small companies
These traits aren't exclusive to large companies. In fact, you can find a number of small companies that meet these requirements and have the opportunity for growth. Here are two great small companies from our Hidden Gems service that illustrate what we mean.
Columbia Sportswear (NASDAQ:COLM) manufactures outdoor apparel. It's trading for just 13 times earnings, carries $239 million in cash and just $7 million in long-term debt, and boasts double-digit returns on equity and assets. Even better, it's been a family business since its 1938 founding, and the Boyles own more than 50% of shares. You can bet they won't let this stock fall too far.
Select Comfort (NASDAQ:SCSS) is the company behind Sleep Number beds. It has more than $100 million in cash and total investments, no debt, and a return on equity approaching 40%! And while it's a little pricier than Columbia at 19 times earnings, it controls its niche and doesn't face much serious competition.
The best part is that both of these solid, well-positioned companies are capitalized at less than $2 billion. That means they have plenty of room to grow.
The Foolish bottom line
In a volatile market like this one, it's absolutely crucial to concentrate on fundamentals and fiscal strength. But don't abandon small companies altogether -- just be a little more careful about the small companies you choose to invest in.
Columbia and Select Comfort are just two of the more than 60 small companies we believe in for the long haul in our Motley Fool Hidden Gems service. Today, Fool co-founder Tom Gardner and senior analyst Bill Mann released their two newest small-cap stock recommendations. You can see today's picks, as well as all our buy reports, with a free 30-day trial. There's no obligation to subscribe, and you might just be able to buy shares of some great small companies while other investors sell them for no good reason at all. Click here for the details.
Tim Hanson does not own shares of any company mentioned. Brian Richards owns shares of Microsoft. Bed Bath & Beyond is a Stock Advisor recommendation, while Microsoft is an Inside Value pick. No Fool is too cool fordisclosure.
