When a group of stocks that led the market out of its tailspin and into one of the biggest rallies in financial history starts to falter, investors pay attention. Now that small-cap stocks have proven that they can't rise forever without a break, the inevitable question arises: is it time to give up on small caps and return to a more defensive posture?
Follow the leader
During the early parts of the rally, small-cap stocks had better returns than their larger counterparts. As the November issue of the Fool's Rule Your Retirement newsletter pointed out, one small-cap index fund gained 90% between March's lows and the end of September, compared to a 57% return posted by an S&P 500 index fund. While many bigger stocks have seen strong returns, the triple-digit percentage gains from companies including ON Semiconductor, Euronet Worldwide, and Teradyne (NYSE:TER) over the past year are relatively commonplace at the smaller end of the stock spectrum.
More recently, though, small caps have given back a small part of their gains. During October, small-cap stocks fell almost 7%, while the Dow stayed relatively flat. Ever fickle, some investors now wonder whether it's time to move on from small caps in search of better returns elsewhere.
Small is smart
Investors who are familiar with small-cap stocks shouldn't have been surprised at their strength earlier this year. Historically, small-cap stocks have enjoyed better performance than larger companies. Precisely because they're smaller, small caps have a lot more room to grow -- and if you pick companies that have great ideas, then the sky's the limit on the gains you can reap.
In addition, trading in small-cap stocks is more efficient than buying and selling large-cap stocks. Big companies like AT&T (NYSE:T) and Google (NASDAQ:GOOG) have dozens of analysts watching their every move, but a tiny stock is lucky to have even a single Wall Street pro poring through its financials every quarter. Their obscurity keeps small caps from gaining a big following early, but it also makes it that much more rewarding when you happen to discover a good company early on.
Don't follow the crowd
Of course, returns like the ones small caps have earned during the rally couldn't go unnoticed for long, and momentum-seeking short-term traders likely contributed to some of their huge gains. And once the numbers showed how well small-cap investors were doing, performance-chasing investors started climbing in as well -- and will probably keep doing so until the market turns.
Whether it makes sense for you to take action with the small-cap stocks in your portfolio depends on why you own them. If you were looking for a quick trade to take advantage of huge bargains during the market meltdown, then you might reasonably conclude you've made all the easy money there is to make, and so selling would make sense. Certainly, big blue-chip stocks like Coca-Cola (NYSE:KO) and Pfizer (NYSE:PFE) have benefits of their own.
On the other hand, if you're a long-term investor in small caps, then there's little reason for you to react at all to the inevitable rotation into other sectors of the stock market. As quickly as big crowds enter the small-cap realm, they can leave just as fast when the time comes. Because some small caps have low trading volumes, massive movements of capital can cause big moves in share prices. Once the exodus is done, though, small-cap investors should see things return to normal -- and you can expect to see the same outperformance they've enjoyed in the past.
How to get in
If you're interested in small caps, there are a number of ways to invest. Apart from buying individual stocks, Rule Your Retirement has a number of funds it recommends. One of the newsletter's favorite small-cap picks has posted a 10-year average annual return of more than 11%. Currently, its holdings include retailer Buckle (NYSE:BKE) and K-Tron International (NASDAQ:KTII).
Many investors never venture far from the big, well-known companies they hear about every day. But some of the best returns come from stocks you've never heard of before. By keeping your eyes open to small-cap stocks, you'll put yourself in a better position to find out about those stocks before they hit the big time.
