Small- And Micro-Cap Stocks: Separating Fact From Fiction

by: Peter Sidoti

Big returns often come in small packages. Since the current bull market started in March 2009, the Russell 2000 index is up approximately 200% compared to a 150% gain in the S&P 500.

In addition, statistics from Vanguard show that between 1927 and 2012, small-cap stocks produced average annual returns of 12.9% vs. a 9.9% gain for their larger counterparts.

With consistent outperformance, why aren't more investors paying attention? Small and micro-cap stocks have often gotten an unfair reputation as being too risky or too volatile for many investors. The truth is, however, we believe those who write off these asset classes are missing out on solid earnings potential from some of the healthiest companies in America.

It's important to correct some of the common misconceptions surrounding this group of stocks. One myth is that there is a diminishing amount of interest and information on small caps. About 14 years ago, perhaps there were two firms covering smalls and micros. Since then, numerous smaller research firms have opened their doors and access to information is greater now than ever.

Here are more myths:

Myth: Operating risk is greater for companies with sub-$2 billion market capitalizations.

KISS. Keep it simple, stupid. Look at the operating risks facing the big guys such as General Electric (NYSE:GE), Citibank (NYSE:C) and ExxonMobil (NYSE:XOM), which have a diverse mix of businesses in just about every country in the world. Every day, they must navigate tricky government regulations, thorny cultural differences and volatile currency swings. These create potential risks that don't exist in smaller companies with much fewer business lines.

Myth: Companies with market capitalizations below $2 billion incur greater financial risk.

Our experience says otherwise. Since the economic downturn of 2008, no company we follow has filed for bankruptcy or required a government bailout. Yet, Thornberg Mortgage (NYSE:TMST), Chrysler, MF Global, Conseco (NYSE:CNO), CIT (NYSE:CIT), General Motors (NYSE:GM) and Washington Mutual all had more than $30 billion of assets when they filed for court protection. We have no ready explanation for this, but we believe the harsh conditions under which banks and other providers of financial services have operated over the past 10 years make the companies in our universe much stronger.

Financial service providers are more selective on companies with which they work and to whom they provide financing. Also, many smaller companies are less confident in their ability to access available financings -- like credit lines -- during times of difficulties, given their experiences in 2008-09.

The successful small cap companies have relied on free cash flow/internal cash flow to finance their operations.

Myth: The managers of small- and micro-cap companies are weak and not focused on shareholder value.

This is completely untrue. Smaller companies typically have large insider ownership. As a result, the interests of management are often much more aligned with those interests of outside shareholders. Any insider wants his $5 stock to turn into a $100 stock as much as the outside shareholders.

Myth: Greater volatility in small-caps suggests there are greater risks for the individual investor.

For true investors, volatility is a positive. Inefficient movements in stock prices allow investors to buy shares at attractive prices and sell shares when prices become excessive. Also, potential returns for small-cap companies often outweigh the risks, as witnessed by the Russell 2000's typical outperformance of the S&P 500.

Myth: There is no institutional interest in small- and micro-cap names.

Most large families of mutual funds offer small and micro-cap investment vehicles, and we note growing interest among institutional investors. These institutional investors know that, unlike large and mid-cap funds, active portfolio management in the small and mid-cap markets can add alpha. Quant funds and ETFs cannot compete as strongly.

Myth: Small companies tend to stay small. They are value traps.

This is another common misconception. The market capitalization of Tractor Supply Corporation (NASDAQ:TSCO) approximated $300 million in 1999. Today, it exceeds $8.5 billion. Polaris Corporation (NYSE:PII) is another great example. Fifteen years ago the company's market cap was approximately $1.8 billion. Now it is over $7.5 billion. Entravision Communication Corporation's (NYSE:EVC) market cap was about $107 million. Today? It's at roughly $500 million. As you can see, strong companies offer tremendous growth potential.

Myth: The IPO market for smaller companies is dead.

Again, incorrect. In the wake of the financial crisis, financial services firms consolidated at an unprecedented rate. In recent years, bulge bracket banks have focused mainly on transactions that support their bloated cost structures. Now, the JOBS Act is prompting resurgence in sub-$100 million IPOs. IPOs from U.S. issuers number 59 so far this year, compared to 58 for all of 2012.

Myth: Trading is difficult in small and micro-cap equities.

Trading has become more and more automated over the past two decades, causing volumes to rise significantly and spreads to narrow.

As highlighted, the Russell 2000 has historically outperformed the indexes of large and mid-cap stocks over almost any time period. The small and micro-cap sectors are filled with companies with good franchises, solid management teams and terrific balance sheets ─ all fundamentals of good investing. So I ask again: why aren't more people paying attention?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.