Given today’s market volatility, investors are craving the equivalent of a market security blanket. The last thing investors want to entertain is the idea of adding small-cap stocks to their portfolio. However, as with all investment sectors, small-cap stocks can contribute to enhanced diversification in your portfolio.
Small-Caps: How to Define?
Small-cap stocks are traditionally defined as those with a market capitalization of less than $1 billion, although they often encompass a range of $300 million to $2 billion. A market proxy for these stocks is the Russell 2000 Index, an index measuring the performance of approximately 2,000 small-cap companies. The weighted average market capitalization for companies in the Russell 2000 is about $1.8 billion with a median market cap of $800 million.
Common perception is that a small-cap company lacks a wide range of financial resources, which may or may not be true. The companies also tend to have a narrower market focus and sales base. It is true that many small-cap companies derive the majority of their revenue from domestic markets, but this is not necessarily a negative. Small-caps are often thought to be more sensitive to tightening credit, as banks demand tougher terms at the first sign of distress. This can be problematic in a rising rate environment, but not for well-positioned and financed firms. Investors must do their research before throwing the baby out with the bathwater and lumping all small stocks in this universe together.
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Small-caps generally tend to be more correlated to the domestic economy. The companies often don’t have the ability to devote production and marketing dollars to both domestic and overseas markets. They therefore derive most of their revenue from the U.S. and aren’t as exposed to international challenges, including a strong dollar. Approximately 80% of the Russell 2000 revenues come from the U.S., vs about 60% for the S&P 500.
Small-cap companies also often have higher growth rates than their larger, more international competitors. Investors tend to expect stellar growth in order to justify the risk they are taking. For this reason, multiples of small-cap companies are often rich versus the broader market.
Small-caps also have limited Wall Street analyst coverage, as analysts are busy covering the large-cap universe. This means a diligent investor who wants to take the time to do the analysis can find values. The small-cap world is also a bigger universe. There are close to 4,000 U.S. publicly traded companies that fit the definition of small-cap versus 1,400 mid and large-cap.
After a terrible 2014, small-cap stocks had a strong first half of the year in 2015, outperforming larger market counterparts. Bio-tech stocks were a large contributor to this outperformance, as valuations soared. Factors driving the positive returns were the economic slowdown in China, collapsing overseas markets, and the strong U.S. dollar, which hurts companies trying to do business abroad.
However, as evidenced by the Russell’s underperformance since July, investor sentiment may be changing as overall markets become more volatile. Investors are now favoring larger, time-tested companies that have withstood historic market swings and survived.
Small-cap stocks offer a unique investment profile. They can shelter a portfolio from the risks of too much international exposure, aren’t influenced by a rising dollar and often offer superior growth rates. However, they also have greater volatility, are more thinly traded and can be easily spooked by Fed actions regarding interest rate movements. Small-caps can play a valuable role in a diversified portfolio and should not be ignored by investors. Stick with high quality companies, or look into a fund that offers a range of stocks such as the Royce Micro-Cap Fund (RMT), the Fidelity Small-Cap Enhanced Index Fund (FCPEX) or the Fidelity Small-Cap Stock Fund (FSLCX).
Note: Elaine Phipps, MBA, CFA, is a Portfolio Manager at Point View Wealth Management, Inc., a registered investment advisor at 382 Springfield Ave., Summit.
Point View Wealth Management, Inc. works with families in Summit and beyond, providing customized portfolio management services and comprehensive financial planning, to develop and achieve their financial goals. We are independent and fee only. How can we help you? Contact David Dietze
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