WHAT IS A SMALL CAP STOCK?

A small cap stock is a company with a relatively small market capitalization, typically between $300 million and $2 billion. There are roughly 1,769 small cap stocks trading in the US stock market, which represents about 3% of the total market. 

Table: Summary of Stocks in the US Market

Small cap companies are younger, less established, and less well-known than large cap companies. Because of this, they are often considered riskier investments due to their limited financial resources, lower liquidity, and higher volatility. 

 

Large Cap vs Small Cap

Many investors tend to favor large cap names, as these companies are more well known, often have more stable cash flows, are lower risk, and most importantly have become popularized by the media and packaged in many widely available ETFs such as the dividend aristocrats, large cap growth or large cap value ETFs, among others. 

While many investors tend to favor large cap names, small cap stocks have several advantages over large cap stocks. 

First, there is long standing academic research showing that small cap stocks tend to outperform large cap stocks over long periods of time. This size premium has been persistent over time, and since 1926, small cap stocks have returned 12% on average, compared to around 10% for large cap stocks.

Looking at a comparison of SPDR’s ETF (SPY), which tracks the S&P 500 index and iShares (IJR) ETF which tracks the S&P Small Cap 600 Index, we can see that an investor would have earned nearly 350% more by investing in small cap stocks since 2000.

There is also some interesting research by Dimensional showing that once stocks become among the largest in the market, they tend to underperform the market over time. This means that if you are an investor looking to beat the market returns over time, large cap stocks typically aren’t the way to go.

WHAT IS SMALL CAP INVESTING?

Small-cap investing can be a valuable strategy for investors who are willing to take on more risk for higher expected returns.

With thousands of small cap stocks to choose from, how does an investor know where to begin looking and which ones have the best chance of outperformance?

In his book 100 Baggers: Stocks that Return 100-to-1, Chris Mayer delved into the performance of stocks that provided investors with a staggering 100-fold return from 1962 to 2014. According to Mayer’s study, the average market capitalization of these exceptional performers was approximately $500 million, highlighting the significant growth potential that can be found in the small-cap segment of the stock market.

This result is not very surprising when we think about how many successful large cap companies we know today such as Amazon, Tesla, Netflix, all started out small.

This means that if you want to find the next Amazon, or next 100 bagger stock, it’s not likely that it’s a large cap stock, rather a small one.

By tapping into this segment, investors have a better chance at finding a future 100 bagger, a company that can grow quickly and compound at above market rates for decades. A large cap company, one with a market cap of more than $10 billion, on the other hand, is not likely to see such growth or returns.

This means that investing in small caps can provide an advantage over large companies, which may have reached their peak potential for growth due to their size and market share.

However, picking individual small cap stocks is no easy feat. This approach is high risk, time consuming, and may not lead to higher returns if you concentrate on only a few small cap names and their growth doesn’t pan out.

Investors seeking to increase their exposure to small-cap stocks while minimizing the time and effort involved may want to consider investing in an exchange-traded fund (ETF) that provides a diversified basket of such stocks. By opting for this approach, investors can potentially boost their returns without the need to pick individual small-cap stocks themselves.

Remember that diversification is really the only “free lunch” in investing, and who wouldn’t like to do less work but still earn more.

Investing in a basket of diversified (quality) small cap stocks can do just that.

However, not all small cap ETFs are created equal. Many small cap ETFs fail to deliver on above market average returns due to the poor construction of the index the ETF tracks.

In the next section I will go over some of the most popular small cap indexes and discuss which ETFs deserve a spot in your portfolio and which you should avoid at all costs.

WHAT IS THE RUSSELL 2000 INDEX?

The Russell 2000 index is the most well-known small cap index. This index includes the smallest 2,000 stocks in the Russell 3,000 index.

iShares (IWM) is an ETF that tracks the Russell 2000 index, and is one of the most popular ways to play the small cap sector. This fund has 1,927 holdings and has a weighted average market cap of $2.97 billion. However, if you are looking to get exposure to the small cap universe, this is not the best index to do so.

Remember that an ETF will only be as good as the index it tracks. Unfortunately, if you are looking to get that desired small cap premium, the Russell 2000 index will not help you get it.

The Russell 2000 index is flawed for a few reasons.

First, this ETF isn’t really a pure small cap play as the ETF’s weighted average market cap is $2.97 billion. This ETF gives you 14.43% exposure to the mid cap growth segment of the market, 39% to small cap value and 46% to small cap growth.

In order to get the small cap premium, the fund needs to be largely exposed to small cap stocks. Meaning, you want the market cap of the fund to be below $2 billion ideally. This fund isn’t the worst I’ve seen, but still has a notable portion of its holdings exposed to mid caps rather than all small caps.

Second, and more importantly, the Russell 2000’s annual rebalancing methodology creates opportunities for hedge funds and traders to profit big as they can easily figure out which stocks will go into and fall out of the index on the rebalancing date and trade those stocks before the index does, reaping significant profits. While at the same time, the average retail investor has seen below the average market returns by investing in this ETF over time.

The third major issue with this index is the loose financial rules that allow companies to enter the index. Namely, companies are not required to be profitable to be included in the Russell 2000 index which is a big explanation for its lackluster returns over time.

For these reasons, investors should avoid investing in small cap stocks through an ETF that tracks the Russell 2000 index.

If you are wanting exposure to the small cap segment of the market, the S&P 600 index is a much better alternative to the Russell 2000 index.

iShares (IJR) is the most common ETF that tracks the S&P 600 index.

Since 2000, IJR has significantly outperformed IWM, by 268.2% to be exact. This means that if you put $10,000 in both IJR and IWM at the start of 2000, and held until now, your investment in IJR would have turned into $66,700 while your investment in IWM would only be $39,880.

That is a $26,820 difference in returns just by choosing the right index to invest in.

Vanguard Small Cap ETF

Vanguard’s small cap ETF VB, is another popular small cap ETF that tracks the CRSP US small cap index.

This ETF holds 1,480 companies and has a weighted average market cap of $6.52B which means the average company in this index is 3x higher than the ones in IJR.

Again, this ETF gives you more of a midcap exposure rather than small cap. This has to do with the methodology the index uses to define the universe of small cap stocks where this index includes US companies that fall between the bottom 2%-15% of the investable market capitalization.

Since January 2004, VB underperformed IJR by 43%, but outperformed the Russell 2000 ETF (IWM) by a long shot (92%).

This should help explain why paying attention to the index your ETF is tracking is crucial for your returns.

SMALL CAP ETF

As a recap, investors should avoid the Russell 2000, and go for ETFs that track the S&P 600 index instead to get a broad exposure to the small cap universe of stocks.

Apart from the ETFs that track the broad small-cap segment of the market, there are other ETFs that offer specialized exposure to specific areas within the small-cap universe. These ETFs aim to capture the performance of small-cap value or small-cap growth stocks, among other segments, which could provide investors with a more targeted and refined approach to small-cap investing.

However, not all of these small cap segments are worth putting in your portfolio. Let’s dive into these other small cap indexes in more detail.

 

Small Cap Value ETF

Another way investors can enhance their returns is by investing in small cap value stocks. Small cap and value stocks are two factors that are expected to increase your returns over the long term. This is because research shows that small cap stocks tend to outperform large cap stocks, and value stocks tend to outperform growth stocks over time.

When combining these two factors, you can further increase your expected returns as these two factors are positively correlated with each other.

You can learn more about that in my recent article on factor investing.

But, the results speak for themselves. Since July 2000, the iShares small cap value fund (IJS) has returned a total 680%, turning an initial $10,000 into $68,060. While the small cap ETF (IJR) returned 595.3% turning a $10,000 investment into $59,530.

Both of these results dwarf the returns earned by investing in an S&P 500 index fund over the same period which turned your $10,000 investment into only $29,960,roughly half of what could be earned by investing in either of the small cap ETFs.

Small Cap Growth ETF

Now, it’s important to note that not all small cap stocks are expected to outperform the market. Particularly, small cap growth stocks are the one exception to this rule.

Small cap growth stocks are characterized as companies with high prices in comparison to their earnings, book value, and cash flow, along with high asset growth and poor profitability. These stocks have historically been the worst performing of the market and resulted in poor returns for investors. 

If their long term track record is so bad, why would investors buy into these funds?

Some investors opt for small cap growth companies that have yet to turn a profit but possess an alluring growth narrative, as they are more likely to experience a surge in popularity due to an exciting development or promising story, resulting in speculative buying and a brief period of exceptional returns.

However, investors should be wary of these situations, as the hype surrounding these stocks can be short-lived and may result in excessive speculation and volatile price swings. While some small cap growth stocks may eventually live up to the hype and will well reward investors who held on, the research shows that the vast majority do not.

The performance among different small cap stocks from 1974-2017 was studied by Dimensional Fund Advisors. They found that small stocks in the highest decile of asset growth (aka growth stocks) only returned 2.2% per year, which was lower than what riskless T-bills paid per year over the 40 years. These stocks also underperformed small stocks in general in 81% of the years.

This means that a prudent choice for most investors is to avoid small cap growth stocks, and instead favor small cap stocks that have a quality filter, meaning they are profitable and have lower asset growth.

Looking at a comparison of performance between small cap funds provides further support for these claims. Since July 2000, the iShares small cap growth ETF (IJT) has significantly lagged both the total small cap ETF (IJR) by 82.7%, as well as the small cap value ETF (IJS) by a staggering 168%.

IS SMALL CAP INVESTING RIGHT FOR YOU?

Small cap investing is suitable for investors who are comfortable with taking on a little more risk for that extra return and are willing to hold onto these stocks for a long period of time.

Investing in individual small cap stocks is very risky but opens up the opportunity for you to find that next 100 bagger. The approach I favor is buying a diversified basket of small cap stocks through the ETF as discussed above which is far less risky than investing in specific small cap companies and has shown to beat the market by a substantial percentage over time when quality is controlled for.

It is worth highlighting that even in a diversified approach, investing in small cap companies carries more risks, these companies are more susceptible to market downturns and are likely to perform worse than a total market ETF during bear markets.

That said, if you have the temperament to weather through the market ups and downs, then adding some small cap exposure to your portfolio is a very effective way to improve your expected returns over the long term.

If you want to actively pick stocks, then you will also need to understand how to do intrinsic value analysis. Here you can find our article on how to calculate the intrinsic value of a stock.

BEST BOOKS ON SMALL CAP INVESTING

Some of my favorite books on small cap investing are Your Complete Guide to Factor-Based Investing by Larry Swedroe. In this book, you will learn about the small cap premium, why it exists, the data behind why it works and how best to capture it through ETFs. If you are interested to learn more about factor investing, make sure to check out this episode with Larry Swedroe.

For those who prefer to handpick individual stocks, then I recommend reading 100 Baggers: Stocks that Return 100-to-1 and How to Find Them by Chris Mayer. In this book he uncovers the essential qualities of stocks that have produced 100 fold returns and discusses the factors that are worth considering to find these gems today. (Spoiler alert, quality small cap stocks are a great place to start).

FREQUENTLY ASKED QUESTIONS ABOUT SMALL CAP INVESTING