Yahoo Finance FP Answers: What’s the best way to pick good small-cap stocks for my investment portfolio?
By Julie Cazzin with Aman Budhwar
Q: After a couple of lucky small-cap stock picks, I’m becoming more interested in adding small caps to my investment portfolio. Small caps don’t get a lot of stock analyst coverage, so how do I know what I’m getting? What role should small caps play in my investment portfolio, what is the typical holding period for these stocks and when do I know if it’s time to sell? Finally, is now — a period of higher inflation — a good time to buy them? — Ava
FP Answers: Small caps can be the unsung heroes of portfolio returns because they often punch above their weight or, in this case, their market capitalization. It has not escaped investors’ attention that, as of August, only seven U.S. large-cap tech stocks accounted for the bulk of returns in the S&P 500. This type of narrow dominance, where a handful of popular stocks attract an outsized amount of capital, means the rest of the publicly-traded companies are overlooked, and no subsector has been more overlooked than small-cap stocks. Indeed, they are probably the most unpopular they’ve been in a very long time.
As a point of comparison, the forward price/earnings ratio of the S&P 500 is 18.5 while the S&P 600 (of small-cap stocks) is at 13.2 This massive difference is all the more remarkable because small caps have historically enjoyed a premium valuation over large caps. Could they become even more unpopular in the near term? It’s possible. But if history is any guide, as markets revert to their mean averages, quality publicly-traded small-cap companies are like a coiled spring and may deliver impressive future returns.
You’re right that small caps receive nowhere near the amount of coverage of large caps. This is not necessarily a bad thing. The relative lack of analyst coverage and price projections mean that there can sometimes be a wide disparity between what a company is worth and its current price. Savvy investors can potentially benefit from this price differential once the valuation gap is closed.
It’s important to distinguish between small-cap and nano- or micro-cap stocks. As per the S&P Dow Jones index classification, small-cap stocks in Canada range in market cap from $25 million to $2.5 billion while the upper range in the United States is higher at US$4.6 billion. In Europe, Australasia and the Far East (EAFE) and emerging markets, the ranges are up to US$8.5 billion and US$10.5 billion, respectively.
Contrary to popular opinion, small caps are not always young and unproven companies. Many small-cap companies are well-established businesses with good balance sheets, and a history of both steady growth and of returning cash to shareholders by way of dividends and share buybacks. Their relative lack of coverage does, however, make it more difficult for the average investor to find quality small-cap companies compared to their large-cap brethren.
There are a number of active fund managers who specialize in small caps, both domestic and international. Even for DIY investors, it may be prudent to outsource this sleeve of one’s portfolio to the specialists.
As to what role small caps can play in your portfolio, there are several proven benefits of having an allocation to them.
First, small caps bring diversification. A well-diversified portfolio decreases risk and volatility, and can create an optimal risk/return balance.
Historically, small caps outperform large caps over the long term, so they can enhance total returns.
Small caps are often domestically focused businesses. During periods of rising inflation, they are better able to raise prices to maintain their profit margins.
The current geopolitical backdrop of international conflict and the trend toward onshoring can benefit domestic businesses as they will face less global competition.
And last, but not least, small caps may become acquisition targets of larger companies, thus providing a profitable exit for shareholders.
As for your question about how long one should hold a small-cap stock, the only honest answer is: It depends. A couple of reasons to sell a position could include if the business changes in a material way that diminishes its prospects, or when the investor finds a more attractive opportunity for their capital.
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By their nature, small caps are less liquid than larger companies that trade millions of shares per day. Their relative lack of liquidity can make an exit more difficult. Investors need to exercise patience and pay close attention to the bid/ask spreads. For this reason, limit orders are advised when trading in small caps.
For the average investor seeking to grow wealth over the long term, an allocation of five to 10 per cent to a small-cap strategy is appropriate. There are periods, such as the one we are currently in, when a tilt toward small caps looks particularly attractive.
Aman Budhwar, CFA, is an associate portfolio manager, Pender Small/Mid Cap Dividend Fund.
