Most investment advisers will tell you that small-cap stocks are riskier than large-cap stocks. And on an individual basis, that’s likely true. However, if you do your homework and dig deep into the financials of small-cap stocks, you can reduce risk and increase reward dramatically.
And that extra bit of work can be well worth it.
Just look at this 10-year chart of the S&P 600 small-cap index (green line) as compared to the S&P 500 large-cap index (black line). Over this time frame the S&P 600 has returned 104%, outperforming large caps by a full 34%.
That outperformance should start to convince non-believers that small caps are not just risky startup companies and IPOs. Many are solid, legitimate growth companies that investors can own for the long haul.
Many of the world’s greatest innovations come from these small, nimble companies. In fact, it is the little guys that have increasingly been investing in research and development in recent decades – and helping to fuel economic growth in the process.
It is this growth that is the reason small-cap stocks shine, since the greatest rate of growth is often during a company’s early days. This is when they are producing new products, launching strategic partnerships and entering new markets. Yet often, they remain overlooked by the investment community.
That creates tremendous opportunity for those that can remain steadfast and buy small caps during market dips and dives.
Picking out the best small caps to invest in does take a fair amount of work. For those looking for assistance, my Game Changers advisory service can help. We’re constantly investing in solid growth companies that have tremendously bright futures, and our returns have been even better than the S&P 600 index in recent years.
If you’re just getting started with small caps and prefer index investing, that’s a great way to go too. Even here though, it pays to do even a little homework to make sure you get into the right ETF.
For instance, the Russell 2000 small-cap index is widely heralded as the benchmark index for small-cap stocks. Data for the index goes all the way back to 1979 (the actual index itself began in 1984).
But the lesser followed S&P 600 small-cap index is, in many ways, the superior index. Although it only dates back to 1994, the S&P 600 still has 20 years of history to consider.
And over that time this index has done better than the Russell 2000. Much better, in fact. Over the last 20 years, the S&P 600 is up by 509%, versus a 304% gain for the Russell.
Shorter time periods show the same result. The S&P 600 has outperformed by 20% over the last 10 years (a gain of 104% versus 84%), and by 17% over the last 5 years (a gain of 114% versus 97%).
There are reasons why the S&P 600 tends to outperform. The main reason is that the Russell 2000 is just the 2,000 smallest stocks among the 3,000 largest stocks in the U.S. stock market. There is no fundamental screen layered in.
Also, the index is reconstituted each year so there are trading events that are well telegraphed to the market. Both of these factors likely lead to weaker performance for the Russell 2000.
In contrast, the S&P 600 index has a profitability screen – companies must have posted four consecutive quarters of profits to be included. And there is no annual reconstitution, so traders can’t game the index – additions and deletions are decided by a committee.
Given that there are low-cost ETFs that track both indexes, it’s really easy for investors to capture the outperformance of the S&P 600.
Just go with the iShares Core S&P Small-Cap ETF (NYSEArca: IJR). I think this growth ETF is highly likely to outperform the iShares Russell 2000 ETF (NYSEArca: IWM) over the next five-, 10- and 20-year periods.
And it’s a very easy way to get started investing in small caps if you’re looking to dip a toe in this profitable asset class, but aren’t yet ready to buy individual stocks.