“Growth is greatest in the early stages of a company’s development.” Cabot Wealth

There is a common perception among investors that over the long term, small-cap stocks outperform large-cap stocks. In exchange for more risk, you get more reward.

As it turns out, this is mostly untrue, according to Seeking Alpha. The best small-cap stocks offer more explosive upside potential, but as a group they don’t really outperform large-cap stocks, subject to a few caveats.

The best possible investing scenario is to identify a top small-cap stock that will go on to become a large-cap stock over the coming years, and go up in value by 10x or 100x.

Unfortunately, for every massive winner that does that, there are multiple losers. Both Russell and Wilshire data show that small-cap stocks don’t really outperform as a group. They’re not bad, but over four decades they don’t really stand out either. Mid-cap stocks are a potential sweet spot, that investors can benefit from either by directly investing mid-cap fund or investing into an equal weight large-cap fund which tends to have a lot of overlap with the mid-cap space.

A 2017 study by Hendrik Bessembinder that analyzed virtually all U.S. public stocks over the past 90 years found that small-cap stocks have much higher performance variance. A smaller percentage of small-cap stocks provide positive long-term returns compared to the percentage of large-cap stocks that provide positive long-term returns. As a consequence, small stocks more frequently deliver returns that fail to match benchmarks.

Conversely, while the absolute best-performing small caps outperform the best-performing large caps over a given period, small caps as a group also have much higher rates of catastrophic loss.

Anytime you buy shares of a small, lessor-known company, there are a plethora of unknowns. Thus, it’s impossible to take the risk completely out of small-cap investing. But there are ways to minimize those risks without sacrificing potential profits.

The defining characteristics of small-cap stocks are that many are young, attractive investments and tend to be highly volatile. This volatility can be absolutely maddening for those who are new to small-cap investing (and even to those who aren’t).

Don’t let this volatility drive you away from small-cap stocks if you’re inclined to invest in them. Volatility comes and goes, and over the long-term small caps tend to beat the market.

FIVE SIMPLE RULES FOR SUCCESS WITH SMALL-CAP STOCKS

It’s important to set up a clearly established set of rules ahead of time, and stick to them. The simple rules that can increase your odds of success, especially during uncertain markets, are:

Rule #1: Commit To The Long Term: One of the more frequently quoted Warren Buffett quips is, “If you aren’t thinking about owning a stock for 10 years, don’t even think about owning it for 10 minutes.”

You don’t need to own every small-cap stock you buy for the next decade. But you do need to look out at least a year or two if you expect to have significant success.

There are select examples of investors making money trading in and out of small caps in the short term. But very few can do it week in and week out, year after year. All the studies say the same thing; your odds of making money go up the longer you stick with small-cap stocks.

A study from Ibbotson, a financial research firm owned by Morningstar, found that investors have a 70% chance of making money with small-cap stocks if they stay invested for one year. That probability goes up to 82% after three years, 86% after five years and 98% after 10 years. The percentages aren’t all that different for large caps.

Rule #2: Dollar Cost Average Your Cost Basis: Small-cap stocks can be irrational in the short term. That’s why you never do anything too drastic. Don’t go all in on an individual stock on a big pullback, or a big breakout. Instead, average into a position by buying shares at different prices and on different days. The strategy helps to reduce the risk of buying a full position in a stock at an unlucky time, which is bound to happen occasionally.

The period over which you average in should be dictated by your holding time horizon. If you’re investing for just a year or two, you’ll probably average in over a week or two, maybe a month. If you’re in it for three or more years, you can average in over a year, or more.

Rule #3: Take Partial Profits: If averaging in makes sense, then averaging out should too. Consider selling a quarter or a half position on the way up, and especially if a gain has surpassed 100%. This doesn’t have to mean giving up on the stock. It’s simply a risk-mitigation strategy. The original capital can be allocated to a lower-risk investment.

Also, it’s fine to average back into a position even if you sold shares at an earlier date. Sometimes, especially during corrections, investors are forced to dump some shares to protect their gains. Months later, the stock might be doing just fine. If the growth story is intact and the market is trending up there’s no reason you can’t build up your position again.

Rule #4: Use a Stop Loss: For small cap stocks, many advisors advocate a 15% to 30% stop loss for large caps. The reason is that you often see quality small caps drop 20% or so during market corrections. Often, these are the times to average down if and when the stock has stabilized, assuming the stock’s growth story is intact,.

That said, it can also be a time to sell a partial, or full, position to protect gains, or help avoid catastrophic losses. How close you are to your desired position size will usually determine if you’re averaging in, or out. The underlying reason for using stop losses is that the bigger the loss, the bigger the return you need to get back to break even (see table below). Don’t go below the red line!

Rule #5: If You’re Not Sure What To Do, Do Nothing: Just because the market is open doesn’t mean you need to participate in it. If you’ve had a streak of losses, or things just don’t feel right, take a break. Focus your attention on a few stocks you’d like to own eventually and read up on those so you’re ready to go when the stock’s margin of safety improves, and your confidence returns.

As Warren Buffett said, “I’ve had periods in my life when I’ve had a bundle of ideas come along, and I’ve had long dry spells. If I get an idea next week, I’ll do something. If not, I won’t do a damn thing.”

Investing in small-cap stocks is a good way to earn huge returns. Consequently, there are two major ways to outperform the market.

• You can take advantage of short-term price dislocation versus a company’s intrinsic value, or
• Use long-term compounding to achieve market outperformance.

References:

1. https://seekingalpha.com/article/4287533-small-cap-performance-gap-doesnt-exist-why
2. https://cabotwealth.com/category/daily/small-cap-stocks
3. https://cabotwealth.com/daily/small-cap-stocks/small-cap-stock-warren-buffett/