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What Are the Risks and Rewards of Small-Cap Stocks?

A heavyweight boxer would likely pulverize a flyweight boxer. But with small-cap stocks, David sometimes beats Goliath. What were the methods and tactics that made men like Warren Buffett and Peter Lynch successful?

Numerous academic studies have found that—over long periods—small-cap stocks tend to outperform large-cap stocks by wide margins. However, small-cap stocks sometimes experience huge volatility swings, especially in declining markets, meaning many investors can’t stomach this kind of uncertainty.

A small-cap stock is generally held to be one valued at less than $1 billion. For instance, if the price of a stock is $10 a share—and a firm has 50 million shares outstanding—then its market capitalization would be $500 million, thus considered as a small-cap company. But the stocks get smaller: a stock with a market cap of less than $100 million is called a micro-cap, and a company with a market cap of less than $50 million is called a nano-cap.

Image of Warren Buffet
Warren Edward Buffett is considered by some to be one of the most successful investors in the world.

Many famous stock pickers—including Warren Buffett, Peter Lynch, and value investors Joel Greenblatt and Seth Klarman—have made enormous sums of money investing in small-cap stocks. Inevitably, however, as the size of their portfolios became quite large, they skewed their holdings to emphasize larger firms. It’s easier to invest large sums of money to work in big firms. If you manage $10 billion and buy a $100 million company that doubles in price, it has a 1 percent impact on the portfolio return, barely a rounding error. Plus, you probably wouldn’t buy the entire $100 million of the company’s stock, only a fraction of it. That would further limit the returns on a $10 billion portfolio. And if—like Buffett—you are managing more than $100 billion, it would be like a grain of sand on the beach.

Most great investors have bought small-cap stocks at one time or another, but few focus exclusively in this area. This can be an advantage for you.

Why do historically, small-cap stocks provide higher returns over large-cap stocks? Studies have found they tend to earn an incremental two or three percentage points more per year than bigger stocks. Though it might not sound like much, these fractional gains can add up to very large differences over time. In short, small-cap stocks historically provide higher returns than large-cap stocks because they are riskier, according to several measures.

Stock Exchange Board Background
One way to measure liquidity is by looking at trading volume.

The first measure is market risk, known as beta. Beta essentially measures the risk of one stock investment against the market as a whole. For example, technology or biotechnology stocks tend to be more volatile than food or utility stocks. Small-cap stocks also tend to be more volatile, and usually have a higher level of market risk or beta than large-cap stocks. These firms are generally less established, have shakier financials, and often do not pay a dividend, and, therefore, exhibit higher market risks. Also, small-cap stocks have higher liquidity risk. A liquid asset is one that can be sold quickly and at fair market value; a liquidity risk entails the danger of trading into or trading out of, an asset with a narrow investor base.

Unlike a U.S. Treasury bill or stock in General Electric, which is liquid, stock in a small-cap stock is usually not. One way to measure liquidity is to look at the trading volume. Trading volume in General Electric averages about 30 million shares a day. By comparison, trading volume in many small-cap stocks is often less than 50,000 shares a day. When institutional investors inject large amounts of money into a company or withdraw it, the act can very easily push the price of the stock up or down. It’s hard for institutional investors to quickly establish a position in a small-cap stock without affecting its price.

There is less information about these neglected stocks due to the lack of coverage, which is a negative to investors who want some handholding. We can refer to this as information risk.

Small-cap stocks are also under-followed by analysts and financial reporters. There is less information about these neglected stocks due to the lack of coverage, which is a negative to investors who want some handholding. We can refer to this as information risk. Wall Street firms often have little incentive to follow small-cap stocks. That’s because bankers who employ research analysts typically get paid a percentage of the size of the deals they work on. So a 5 percent fee for issuing a billion dollars worth of equity—something a large-cap company like Tesla might do—would be a lot more lucrative for an investment bank than would be helping a small-cap firm issue $100 million’ worth of equity. Bankers are more inclined to pour research resources into larger sources of fees than smaller ones.

The Positive Side of Smal-Cap Stocks

Market risk, liquidity risk, and information risk might be seen as a negative from some perspectives, but they can be positive from another perspective. Higher risk investments generally result in higher realized returns and are primarily why small-cap stocks historically return 2 or 3 percent more a year than do large-cap stocks. It takes several years to capture that extra premium and often more than a decade.

Jeff Bezos at Amazon Spheres Grand Opening in Seattle.
Jeff Bezos’ management of Amazon helped the company’s technology stock perform very well during the 1990’s internet bubble.

For example, during the internet bubble in the late 1990s, large technology stocks like Dell, Microsoft and Amazon did very well. Small-cap stocks, especially those outside the tech sector, typically couldn’t keep pace. As a result, their indexes underperformed large-cap stock indexes five years in a row. It takes patience and the ability to stomach market volatility to be a small-cap investor. Small-cap stocks historically exhibit about 40 to 50 percent greater volatility than large-cap stocks do. Of course, this often comes during down markets. A Wall Street expression demonstrates the point best: “You don’t know your risk tolerance until you live through a bear market.”

Both active and passive small-cap strategies can help the investor navigate the rises and falls of the market. Starting with the passive methods, the easiest way to invest in small-cap stocks is through an index fund or an exchange-traded fund—known as an ETF. Index funds and ETFs are baskets of stocks. The first small-cap index was created in 1984 by Frank Russell and Company. It is known as the Russell 2000 Index.

Out of a universe of 3,000 stocks, Russell established the first widely referenced small-cap index in 1984 by creating a basket of the lower or smaller 2,000 stocks. Lower or smaller is determined by market cap. With this, index funds—and later, exchange-traded funds—created an opportunity for investors to become active in the small-cap market without having to individually research and select small stocks. The index is rebalanced, or reconstituted, each June. The rebalance process accounts for changes in firm size, for firms leaving the index due to mergers or bankruptcies, and firms entering the index due to initial public offerings or spinoffs. The companies in the Russell 2000 Index usually range in size from a couple of hundred million dollars in market cap up to $5 billion. But the average valuation of a stock in the index is about a billion dollars.

The Frank Russell Company was started by its namesake out of Tacoma, Washington, in 1936. It began as a brokerage firm. His grandson, George Russell, is the one who really developed the firm. George graduated from Harvard Business School in 1958 and was thrust into running the company a few months later after his grandfather’s unexpected death. George grew the firm, especially in the area of institutional investment consulting.

One of the common things consultants do is measure performance. There were well-known stock indexes for large firms, such as the Standard & Poor’s 500 and Dow Jones Industrial Average, but there was nothing for small-cap stocks. Hence, the birth of the Russell 2000 Index. It is the most widely followed small-cap index today. More than 90 percent of small-cap investment managers use the Russell 2000 as their benchmark. Standard and Poor’s, or S&P, also has a small-cap index of 600 names, but it hasn’t gained as much traction as Russell’s.

Investing Skill, Strategy, and Temperament

In the early 1990s, Eugene Fama at the University of Chicago, and Ken French, then at Chicago—now at Dartmouth College—provided further insight into the large versus small-cap performance discrepancy. They verified the finding that small-cap outperforms large-cap over long periods. But they combined it with this factor: value typically outperforms growth over a long time. Academics typically differentiate between value and growth by metrics such as price-to-earnings and price-to-book. The price-to-earnings, or P/E ratio, is measured as the price of a stock per share, divided by the earnings per share. Stocks that have above-average P/E, typically higher than 15, are considered growth stocks. Stocks with a below-average P/E are considered value stocks.

The numerator of the price-to-book ratio is also the price of a stock. The denominator, or book value, is the same as the wet worth, or shareholder equity figure, on the balance sheet. It’s measured by starting with all of the assets of the firm and then subtracting all liabilities. A firm with an above-average price-to-book ratio, typically higher than 2.5, is considered a growth stock. Firms with a price-to-book value of less than average are considered value stocks.

Fama and French don’t view their findings on small-cap and value investments as the holy grail. Rather, they think small firms and value firms have higher risks, such as being more prone to bankruptcy, one reason why they have higher returns. The Fama-French findings were put into action by the investment firm Dimensional Fund Advisors or DFA for short. DFA was set up in 1981 by two of Fama’s students from the University of Chicago, David Booth and Rex Sinquefield. Booth may be a recognizable name; he donated $300 million to the University of Chicago, who named their business school after him. DFA put many of the ideas of Fama and French to work across a range of products, including many low-cost index funds. Fama and French also serve on the Board of Directors and act as consultants to DFA. Today, the firm manages more than $400 billion for clients.

Tracking Warren Buffet’s Success

Warren Buffett is well-known for his investing prowess in large firms such as Coca-Cola, American Express, and Wells Fargo. But earlier in his long and storied career, Buffett managed much smaller amounts of capital and had incredible success with small-cap stocks. He’s often said that managing large sums of money results in a performance disadvantage. It forces him to hunt for elephants, or large firms, to have a meaningful impact on his portfolio’s overall performance. In one interview, Buffett said that if he were managing only a million dollars—instead of tens of billions of dollars—he would guarantee that he could achieve returns of 50 percent a year since he would have no constraints on a target’s size, and not worry about his investment’s market impact on the price when taking a position.

Buffett once was asked where individual investors should look for investments. Buffett replied that he thought small-cap stocks were great hunting grounds because large institutions can’t invest there, practically speaking. He gave the example of investing in small-cap stocks in South Korea, where the price-to-earnings ratios of many firms were only three times earnings, at the time—about 80 percent cheaper than the values of large U.S Stocks.

Buffett replied that he thought small-cap stocks were great hunting grounds because large institutions can’t invest there, practically speaking.

Berkshire’s acquisition of See’s Candy in 1972 provides a good case study on Buffett’s approach to small-caps. See’s Candy is a California-based maker of chocolates and other confectionary items. It was founded in 1921 by Charles See and had a great product and a loyal following. Buffett had a second home in California and he also loved the product, after it was brought to his attention back in 1971 by his business partner, Charlie Munger. Buffett thought there was a lot to like about See’s. The product tastes great, it is a consumable, which ensures recurring revenues, it has a fanatical following, a great brand name, the ability to raise prices, and the company required little R&D or capital expenditures to keep the business going. It’s also hard for a firm like to displace it.

In sum, it’s a great business. But the high-end chocolate business will never be a huge industry, compared to the auto industry or the cell phone industry. This means it is destined to stay relatively small, and therefore would be under the radar screen of large fund managers. See’s was also a private, family-owned business. As the principals of the firm aged, the family decided to sell the firm to Berkshire for $25 million. At the time, See’s was doing about $30 million in annual revenue and generating $4.2 million a year in profits. A few years later, the business was doing about $400 million a year in sales and about $100 million a year in profits. Its cumulative profits since Buffett bought the firm are more than $1.5 billion.

Buffet Makes A Bold Investment

Buffett’s most famous small-cap investment was in Berkshire Hathaway itself. Today, Berkshire is one of the largest companies in the world, with a market cap in the hundreds of billions of dollars. But Berkshire started in 1839 as a textile maker. Although textiles were once a thriving business in America, the business was—like many manufacturing industries—gradually outsourced overseas. Berkshire was also headquartered in the New England area and operated most of its plants there. That was a pricey area to operate factories, especially as the services industry in the Northeast prospered.

Today, Berkshire is one of the largest companies in the world, with a market cap in the hundreds of billions of dollars. But Berkshire started out in 1839 as a textile maker.

Buffett first started buying Berkshire in 1962, for $7.60 a share, for his own investment firm, which he had then called the Buffett Partnership. Even then, Buffett could see that the textile manufacturing business was a declining business in the United States. But he saw value in the firm, in the form of its working capital, real estate, plants, and equipment. He also held out hope that the company would be able to turn around, or at least stabilize its declining fortunes. Buffett paid $14.86 a share to gain control of Berkshire in 1965. At the time, Berkshire had net working capital of $19 a share—that is, current assets minus current liabilities—plus valuable property, its plant, and equipment. Buffett acquired the company for basically nothing.

Berkshire had more than enough capacity to handle its declining business and it didn’t require a lot of new capital expenditures. The business threw off a lot of cash. Although Berkshire eventually left the textile business, the genius of Buffett was that he used its cash flow to help buy many other companies, either outright, or in part through their stock. These included companies such as The Washington Post, See’s Candy, Coca-Cola, Dairy Queen, Burlington Northern, Wells Fargo, and especially, Geico insurance, a business that generated a lot of cash itself. Ultimately, through wise capital-allocation decisions, Buffett turned a small-cap company into one of the largest in the world.

Ultimately, through wise capital-allocation decisions, Buffett turned a small-cap company into one of the largest in the world.

Peter Lynch’s Winning Strategies

Another famous investor that did well with small-cap stocks is Peter Lynch. He turned Fidelity Investments’ Magellan fund into the largest mutual fund in the world by the time he stepped down. A $1,000 investment in Magellan when Lynch started there in 1977 had turned into $28,000 by his retirement 13 years later. A significant part of Lynch’s outperformance was due to his investment in small-cap firms. Even after Magellan became large—with an investment portfolio in the tens of billions of dollars—Lynch didn’t completely abandon small-caps. He wound up owning more than 1,000 stocks in Magellan. It was only by investing in such a large number of small-cap stocks that he was able to get them to have a meaningful effect on Magellan’s returns. The resources of Fidelity helped him find and monitor all of these companies.



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