3 Reasons to Own Small Caps

If you scour the media for investment ideas, you’ll undoubtedly come across plenty of advisors touting large-cap names. The liquidity of these stocks, along with the dividends many larger companies pay, makes them especially good components in a portfolio.

However, small caps can be outstanding vehicles to add excess returns.  Many individual investors overlook these opportunities, though, because the companies are not always household names – and they seldom get much media coverage.

So why should you be looking at smaller stocks? Why do these hold such potential? There are a few reasons that I wanted to examine:

1) Small caps that have recently had their IPOs are often big winners.

First, many smaller companies are relatively new, or at least newly public. By “newly public,” I mean having IPO’d within the past decade or so, not necessarily the stock that made its market debut yesterday with much media fanfare.

Often, some of the strongest stocks went public with little or no attention. For example, connectivity product maker Ubiquiti Networks (UBNT) went public at $15 a share in October, 2011. The stock had a relatively quiet debut, but notched a gain of almost 40% in its first six weeks.

In the autumn of 2011, the media was fixated on the upcoming IPOs of social-media companies Groupon (GRPN) and Zynga (ZNGA), so other new issues flew below many reporters’ and analysts’ radar.

Between its December, 2011 debut and mid-March, 2012, Zynga managed a gain of 30% from its $10 IPO price.

The much-touted Groupon lost about 1% between its November IPO price of $20 and mid-March, 2012.

Meanwhile, the unheralded Ubiquiti Networks, which made its debut at $15, was trading at $26.92 as of the close on March 16. That was a gain of 79%.

So what’s the point? Not that “famous” stocks can’t be winners. Of course they can. Google’s (GOOG) 2005 IPO is a great example of this.

But be careful not to overlook small, unknown companies just because they are not recipients of the media hoopla that supposedly sexier companies get.

(I have a theory that many stocks fly under the radar because reporters don’t understand their businesses – and don’t want to be bothered, because others are more “fun.” But that’s a story that I’ll continue to follow throughout this blog.)

Of course, many of these lesser-known, yet new, companies are small caps. As they grow, they can enter into mid-cap range and become the high-fliers that the media begins to chatter about.

Take Lululemon Athletica (LULU) as a case in point. At its 2007 IPO valuation of $18, the stock had a market cap of $1.24 billion.

A few short months after its Nasdaq debut, the entire market plunged, taking Lululemon (and for all intents and purposes, everything else) with it. But shares rallied back strong after a new bull market emerged in March, 2009 and Lululemon went on to become a mid-cap leader.

It’s not uncommon to see younger companies like Lululemon join the ranks of the market’s best price performers. Of course, not all new companies are small caps – but quite a few are!

Newer small caps that boasted big gains in the first quarter of 2012 included not Francesca’s Holdings (FRAN)Rentech Nitrogen Partners (RNF)Spirit Airlines (SAVE)Imperva (IMPV)Tangoe (TNGO)Invensense (INVN), and Mattress Firm (MFRM).

Several of those names may be unfamiliar, but that’s exactly the point! Frequently, small-cap companies you’ve never heard of can be very lucrative additions to your portfolio.

2) Small cap companies can more easily ramp up their sales and earnings growth

One of the small-cap analyst shops that I really respect is Wyatt Research. Its CEO, Ian Wyatt, explains here why revenue, in particular, is a key metric to track in smaller caps. He writes, “The truest way to measure real growth is to identify whether the company is selling more – and how much more – on a year-over-year basis. Dollars can be maneuvered around the income statement to massage earnings, but it is very difficult to massage top-line revenue.”

Smaller companies often have more focused lines of products and services, meaning managers must devote attention to growing those specific areas. Attention is not scattered across disparate business units, or, in many cases, across geographies.

In addition, as noted earlier, many small caps are fairly young companies, meaning they have plenty of room to grow revenue at rapid rates. More mature companies typically show slower year-over-year sales increases.

And because growth at smaller companies is ramping up so fast, investors pile in, sending the stock higher.

3) It’s easier for individual investors to get in and out of these stocks quickly, whereas institutions can’t.

There are most definitely small-cap funds – and some, like this one, perform very well. But a good number of institutions need to maintain the liquidity found only with larger stocks. Because some of the bigger mutual funds, pension funds, and hedge funds have vast sums of money to invest, larger stocks make more sense.

Frequently, smaller caps are more thinly traded, meaning that there’s really not room for more funds to crowd into the trade. In addition, the thin trade means it’s easier for one or two big buyers – or sellers – to send the stock sharply in one direction or the other.

In contrast, it’s easier for retail investors to get in and out of small caps, even microcaps and nanocaps. By using trading rules, you don’t have to be stuck in a losing stock when it breaks key support levels in heavy volume.

Institutions, on the other hand, don’t have that kind of flexibility, and often sit though a steep downturn. Retail investors can cut losses and keep them small, or pocket profits before a downturn wipes out paper gains.

Of course, smaller stocks do carry extra risk – exactly because institutions can’t be scooping up shares, as they could with a larger company like Apple (AAPL) or Exxon Mobil (XOM) or McDonald’s (MCD).  This is where a set of trading rules is imperative. That’s true with a stock of any market cap, but especially in a smaller company that can be prone to sharp price swings.

It’s easy to get caught in a downdraft if you’re not careful with thinly traded small names. However, they also can bring big rewards in the form of price appreciation to investors who trade carefully.

Kate Stalter is a columnist for RealMoney.com, MoneyShow.com and Morningstar Advisor. Stalter currently hosts “The Small Cap Roundup” on TFNN.com, every Tuesday and Thursday at 11 a.m. Eastern. She serves as editor of the “Low-Priced Leaders” newsletter, also at TFNN.

From 2001 until 2010, she was a market writer at Investor’s Business Daily and presented the “Market Wrap” and “Daily Stock Analysis” videos at Investors.com.  Stalter co-hosted webcasts with TDAmeritrade,  and regularly taught IBD investing seminars nationwide.

 She received her MBA in finance and marketing from the Kellogg School of Management at Northwestern University. 

 You can follow Kate on Twitter @katestalter and receive her free monthly newsletter at www.katestalter.com




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