Investing in Small Cap Stocks

Small cap stocks are an important part of a diversified investment portfolio. They had provided high historical return and diversification, which are key factors in the portfolio management process.

Many flagship companies started as small businesses in a local market and evolved to large multinational corporations. Some of these success stories include McDonalds, which opened its first restaurant in Des Plaines, Illinois to become one of the biggest food chains in the world.

Research has shown that small-cap stocks overperformed a large cap over an extended period.

The below chart shows 15-year performance between IWM, Russell 2000 Small Cap ETF and SPY, S&P 500 Large Cap ETF. For that period IWM surged by 164% while SPY rose by 67%.

Once we include dividends, the 15-year annualized return of a small cap blend strategy becomes 8.66% versus 6.71% for a large cap strategy.

If we extend our period to 40 years (1975 – 2015), the small cap generated 14.25% annualized return while large cap produced 11.66%.

Investing in small companies comes with many caveats.  Even though they bring potentially high returns, they also impose high risk and uncertainty.

Small cap stocks market capitalization

Small cap companies have a market capitalization between $300 million and $2 billion dollars. Overall, the small size market is very fragmented. There are thousands of publicly traded small-size companies, but they only make 10-15% of the total market. The definition of a small-cap company varies widely among index providers and portfolio managers. Standard & Poor’s tracks their own S&P 600 Small Cap Index while FTSE Russell tracks the Russell 2000 Small Cap Index.

Very often, small companies are managed by their original founders.  They are usually new and innovative companies with competitive strengths in a particular local market or a specific product. It is not uncommon for companies to go back and forth between small, mid and large-cap rankings depending on their business cycle.

Niche market

Small cap companies often operate in a niche market where they have a distinct competitive advantage. Small businesses have a unique product or service, which they offer on either national or local level.  Unlike their bigger counterparts, which offer a variety of products in different geographies, small size companies tend to be more focused, with one or two flagship products. A particular example can be Coca Cola versus Red Bull. Coca-Cola offers hundreds of varieties of beverages worldwide while Red Bull offers only one type of energy drink.

Regularly small companies will start from a local market and grow nationwide.  Starbucks is a great example of a local coffee shop that moved up the ranks and became one of the top 100 large company in the USA and the world.

Small businesses with a unique product will often become an acquisition target for a larger corporation that wants to gain a presence in a growing higher margin market. Great example for that is PepsiCo acquiring Gatorade. PepsiCo wanted to get access to the fast growing market of sports drinks and instead of developing their own line; they decided to purchase an already established brand.

Growth potential

Small cap companies often have higher revenue growth than large size ones. Their competitive advantages, innovative strategy, flexibility and market positioning allows them to grow faster. It is easier to increase 25% when you start at $10 million of revenue versus $25% at $ 1 billion of revenue. Many times small companies do not even have a competition in their market niche. Think of Facebook before they went public. It is common for small firms to grow their revenue between 25% and 50% annually for several consecutive years.

Volatile prices

Investing in small cap stocks is risky. The high potential return of small caps comes with greater risk. The share price of small companies is more volatile and subject to larger swings than those of bigger companies.

IWM, the biggest small-cap ETF, has a beta of 1.22 to the equity market. As the comparison, the beta of SPY, the most traded large-cap ETF, is equal to 1. Beta measures the volatility of a security compared to the market as a whole. IWM beta of 1.22 shows that the ETF is historically 22% more volatile than the overall market.

Another measure of volatility is a standard deviation. It illustrates how spread out are the historical returns compared to the average annualized return of the investments. In our case, the 15-year standard deviation of IWM is 19.73% versus 14.14% for SPY.

As I mentioned earlier, the average 15-year return for a small cap stock is 8.66%. With a standard deviation equal to 19.73%, an average annual return can go between -11.07% and 28.39%. For SPY the average range is between -7.43% and +20.85% with annualized return of 5.25%. Based on this historical data we can claim that the small cap market has a much wider probability of returns. The high upside comes with a bigger downside.

Limited access

Small cap stocks lack the liquidity and trading volume of the large public corporations. This makes them more vulnerable to large price swings in short periods.

In times of economic recession, small companies can take a bigger hit in their earnings and may take a longer time to recover. Ten or fifteen percent decline in revenues can have a much more adverse impact on a small company than a larger one.

Due to their limited access to equity markets and loan financing, small size companies have a higher risk to go into bankruptcy if they run out of money.

Many small firms are start-ups with one innovative product and untested business models. Their dependency on just one product or service puts them in a very high-risk category in cases when the product or service does not appeal to their target customer base.

Inefficient market

Traders and portfolio managers often ignore small-cap companies. The focus is usually on large size companies, which frequently have 5 to 10 analysts following their earnings.  In fact, research analysts cover very few of the 2,000 stocks in the Russell 2000 index. Therefore, it is common that a small company does not have a full coverage by any industry analysts. This lack of interest and publicity produces conditions for inefficient pricing.   Active investors with a focus on the small cap market can scan the universe for undervalued and mispriced stocks and generate higher returns based on their valuation techniques and knowledge of the market.

Diversification

Investing in small cap companies can significantly contribute to the diversification of your portfolio.  Even though small stocks have a higher risk than larger ones, their correlation to the overall market is lower. A small blend strategy has 0.86 correlation to the overall US stock market and 0.56 to the broader international stock market.

A correlation equal to 1 shows the highest strength of the relationship between two asset categories. In the case of small cap, the correlation of 0.86 shows a weaker link with the overall market. Small cap prices does not fluctuate in the same magnitude and pace as the large cap companies.  While there is some influence by S&P 500, they follow an independent path.

How to invest in small cap stocks

Individual stocks

You can invest in small size companies by buying them directly on the open market. There are over 2,000 listed small size companies in various industries and stages of their business cycle. Naturally, you cannot invest in all 2,000 stocks. You have to find a way to narrow down your criteria and select stocks based on certain factors. Very few small companies have analyst coverage. Therefore investing in small caps stocks will require doing your own research, analysis, and valuation.

When you invest in any company directly, being that a small or large size, you have to keep in mind that concentrated positions can adversely affect your portfolio performance if that company has a bad year or goes bankrupt. While everyone’s risk sensitivity is different, I would recommend limiting the range of each individual stock investment to 1% – 2% of your portfolio.

Tax Impact

For the best tax impact, I recommend putting small cap stocks either in taxable or Roth IRA accounts. Small cap companies have higher expected return combined with a higher expected volatility. If you hold your stocks in a taxable account, you can take advantage of tax loss harvesting opportunities if a particular stock in your portfolio is trading at lower levels than original purchase price. Tax loss harvesting is not available in Roth IRA, Traditional IRA, and 401k accounts. I

If you have small-cap stocks with solid long-term return prospects, keeping them in a taxable account will also allow you to pay the favorable long-term capital gain tax when you decide to sell them.

Having stocks in a Roth IRA account will have even better tax treatment – zero tax at the time of sale.

Passive indexing

ETFs and index mutual funds are the top choice for passive small cap investing. They provide a low-cost alternative for investors seeking a broader exposure to the small cap market. Small cap ETFs come in different shapes and forms. The table below shows a list of the most traded small cap ETFs with AUM above $500 million:

List of Small Cap ETFs

TICKER	FUND NAME	EXPENSE RATIO	AUM	SPREAD %	1 YEAR	5 YEAR	10 YEAR	SEGMENT	AS OF
IWM	iShares Russell 2000 ETF	0.20%	$27.79B	0.01%	5.69%	12.28%	6.01%	Equity: U.S. – Small Cap	10/26/2016
IJR	iShares Core S&P Small Cap ETF	0.07%	$20.83B	0.03%	7.35%	14.16%	7.56%	Equity: U.S. – Small Cap	10/26/2016
VB	Vanguard Small-Cap Index Fund	0.08%	$13.94B	0.03%	5.59%	13.14%	7.40%	Equity: U.S. – Small Cap	10/26/2016
VBR	Vanguard Small Cap Value Index Fund	0.08%	$8.16B	0.04%	7.31%	14.20%	6.77%	Equity: U.S. – Small Cap Value	10/26/2016
IWN	iShares Russell 2000 Value ETF	0.25%	$6.72B	0.01%	9.39%	12.17%	4.82%	Equity: U.S. – Small Cap Value	10/26/2016
IWO	iShares Russell 2000 Growth ETF	0.25%	$6.35B	0.02%	1.92%	12.31%	7.01%	Equity: U.S. – Small Cap Growth	10/26/2016
VBK	Vanguard Small-Cap Growth Index Fund	0.08%	$4.93B	0.04%	3.50%	11.36%	7.25%	Equity: U.S. – Small Cap Growth	10/26/2016
IJS	iShares S&P Small-Cap 600 Value ETF	0.25%	$3.85B	0.03%	10.26%	14.31%	6.57%	Equity: U.S. – Small Cap Value	10/26/2016
SCHA	Schwab U.S. Small-Cap ETF	0.06%	$3.78B	0.04%	5.46%	13.03%		Equity: U.S. – Small Cap	10/26/2016
IJT	iShares S&P Small-Cap 600 Growth ETF	0.25%	$3.47B	0.08%	4.41%	13.74%	8.42%	Equity: U.S. – Small Cap Growth	10/26/2016
DES	WisdomTree SmallCap Dividend Fund	0.38%	$1.59B	0.12%	11.96%	14.36%	6.35%	Equity: U.S. – Small Cap	10/26/2016
FNDA	Schwab Fundamental US Small Co. Index ETF	0.32%	$1.04B	0.06%	6.38%			Equity: U.S. – Small Cap	10/26/2016
SLYG	SPDR S&P 600 Small Cap Growth ETF	0.15%	$807.64M	0.27%	4.61%	13.74%	9.00%	Equity: U.S. – Small Cap Growth	10/26/2016
VTWO	Vanguard Russell 2000 Index Fund	0.15%	$675.74M	0.06%	5.67%	12.19%		Equity: U.S. – Small Cap	10/26/2016
XSLV	PowerShares S&P SmallCap Low Volatility Portfolio	0.25%	$651.46M	0.09%	12.43%			Equity: U.S. – Small Cap	10/26/2016
SLYV	SPDR S&P 600 Small Cap Value ETF	0.15%	$610.42M	0.21%	10.46%	14.43%	7.38%	Equity: U.S. – Small Cap Value	10/26/2016
SLY	SPDR S&P 600 Small Cap ETF	0.15%	$512.80M	0.25%	7.10%	13.99%	8.19%	Equity: U.S. – Small Cap	10/26/2016

Benchmark

One of the main differences between small-cap ETFs is the index they track. Each of the three main Small Cap Indexes is constructed differently.

Russell 2000 (IWM) includes the bottom 2,000 of the largest 3,000 publicly traded companies. The average market cap of the constituents of Russell 2000 is equal to $1.9 billion. The median is 698 million. And the largest stock has a market cap of $6 billion.

S&P 600 Index (IJR) tracks a smaller subset of the market. It includes only 600 companies.  As of April 2016, the market capitalization of companies included in the Index ranged from US$ 400 million to US$ 1.8 billion. S&P 600 also sets additional requirements for liquidity, public float, sector and financial viability.

CRSP SmallCap index (VB) tracks the 2%-15% percentile of the total market. It has 1,462 companies. The smallest company has a market capitalization of $21 million; the largest has $7.9 billion. The average size is $1.85 billion. The median is $1.44 billion. It is worth noting that VB tracked Russell 2000 Index through May 16, 2003; MSCI US Small Cap 1750 Index through January 30, 2013; CRSP US Small Cap Index thereafter

Focus

Another big difference between Small Cap ETFs is their segment focus. There are three main segments – small cap blend, growth, and value. The blend strategy invests in the wide universe of small caps, which mechanically tracks the designated index. The value strategy tracks a specific group of companies that have a  certain level of Price to Earnings, Price to Sales, Price to Book, dividend yield, and other fundamental ratios. Growth strategy invests in a group of stocks that meet certain criteria for price, revenue and earnings growth.

Tax Impact

ETFs and index funds have more favorable tax treatment than actively traded mutual funds. Due to their passive nature and legal structure, these funds rarely release capital gains and losses to their shareholders. Therefore, investors looking to optimize taxes in their investment portfolio should consider these type of funds.

Active investing

This strategy includes investing in actively managed mutual funds. These funds are run by management teams. They normally charge higher fees than comparable ETF to cover for the trading, administrative, marketing and research expenses.  Mutual funds follow a benchmark, which is usually one of the three main indices described earlier – S&P 600, Russell 2000 or CSRP Small Cap Index. Because of their higher fees than comparable ETFs, fund managers are often expected to outperform their benchmark.

Active funds normally focus in one of the three main segments – blend, growth or value. The fund managers utilize a formal selection process that identifies a number of companies, which meet certain proprietary criteria. The end goal is to select those companies that will achieve a higher return than the undying benchmark. Since the characteristics of value vs. growth strategy can be subjective, it is not an unusual that the same company is owned by both value and growth oriented funds.

In the past 7-8 years, many of the active managers have been criticized for underperforming the market. Part of the reason is that we experienced a very long market rally driven by a small number of flagship companies.

Tax Impact

Actively managed mutual funds have a more complex tax structure. They must transfer most of their dividends and capital gains and losses to their shareholders. Mutual funds will often have large amounts of long or short-term gains and losses released in December regardless how long you had kept in your portfolio, to avoid paying additional taxes I recommend placing your actively managed mutual funds in tax deferred and tax exempt accounts. Another alternative is to look for tax-managed funds. They tend to have a low turnover ratio and tend to report long-term gain and losses less frequently.