"THE SMALL-CAP APOCALYPSE IS NIGH"
That wasn't an actual headline, but it might as well have been. With back issues of The Wall Street Journal protecting our bedroom floor as my wife and I painted last weekend, I got a panoramic view of just how much negative press small-cap stocks have been receiving lately. Here's a sampling:
"Tide Turns to Large-Cap Value Stocks" (June 28)
"Small Stocks Bear Brunt of Fall" (June 19)
"Rally Plundered" (June 7)
"Favor Funds in Big Stocks" (May 28)
"Mood Shifts on Wall Street" (May 26)
"Small Stocks Lose Some Strength" (April 8)
Danger in numbers
This isn't to say that these headlines aren't accurate. They are. The Russell 2000 small-cap index is down 5% since early April, and large caps are presenting some compelling valuations right now. Fannie Mae (NYSE:FNM), DR Horton (NYSE:DHI), ConocoPhillips (NYSE:COP), and Chesapeake Energy (NYSE:CHK), for example, are all trading at attractive single-digit price-to-earnings ratios.
Yet despite that slide, the Russell 2000 is still up 6% for the year. And a 6% return for six months of work isn't that bad relative to the large-cap-laden S&P 500, which is up just 2%.
Given those headlines, one would think the small-cap situation is much worse than it is. But that's the problem with most of the financial media (and even many investors). They focus too much on the short term (which is statistically insignificant) and not enough on the long term (which is where the real rewards lie).
The promise of small stocks
Consider, for example, that all 10 of the best stocks of the past 10 years were once obscure, small companies. Moreover, small-cap value stocks outperformed the broader market by nearly six percentage points annually (12.13% vs. 6.72%) from 1927 until 2005, according to moneychimp.com.
Running those numbers over a 30-year period with a $10,000 initial investment, a small-cap value strategy would have earned you more than $310,000, while a total stock market strategy would have earned you just $70,000.
That's a massive $240,000 opportunity loss if you ignored small caps in your portfolio.
Hang in there
But that example is a little too cheeky to justify this article's snappy title. To truly avoid massive losses in small caps, don't be so quick to sell.
Seriously, don't.
While it's true that small caps are among the most volatile securities on the market, paper losses aren't real losses until you sell the stock. To mine a few examples from our Hidden Gems small-cap service, Blackboard (NASDAQ:BBBB), Nuance Communications (NASDAQ:NUAN), and Drew Industries (NYSE:DW) each suffered double-digit drops since the beginning of May. Yet those stock-price failings haven't correlated with failings in any of these businesses. Indeed, all three have started to rebound and we are confident that these three businesses will make investors happy for many years to come.
The Foolish bottom line
Simply put: History shows that small caps are among the best stocks to own. But sticking with them can be tricky business. The stocks are volatile, and drops can hurt your short-term bottom line. But if you have the patience to stick to your guns and stomach the volatility, you may save yourself from massive losses and find some excellent investment opportunities along the way.
If you'd like some help navigating the small-cap waters, click here for a 30-day free trial of Hidden Gems. Our small-cap investment service is beating the market by more than 24 percentage points, and you can rest assured that we're in this for the long haul (Wall Street Journal headlines be darned!).
For related Foolishness:
- The Market's 10 Best Stocks: Find out which 10 stocks gave investors the highest returns over the past decade -- and what they had in common.
- The Market's 10 Worst Stocks: Equally instructive is the plight of the 10 worst-performing stocks since 1996 (excluding bankruptcies and penny stocks). Find out what you can learn from their mistakes.
- 70 Times Better Than the Next Microsoft: Small caps should be a part of your portfolio, but you shouldn't invest in just any basket of small companies. Years of testing show that true returns lie in small-cap value stocks.
Tim Hanson owns shares of Blackboard. Fannie Mae is an Inside Value recommendation. No Fool is too cool for disclosure.
