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The Case For Small Caps

Historically, small-cap stocks have outperformed their larger counterparts, and in modern-day, the performance of the segment is keeping up its pace. Research shows that small-caps have outperformed large-caps by roughly 40% in seven of the past 10 years. A 2011 study weighing the annualized return of the S&P 500, the Russell 2000, and the Russell 2000 Value over the course of a year found that the S&P yielded returns of 0.50% while the Russell indexes generated 4.61% and 8.30%, respectively. For faring so well, the small-cap segment is generally overlooked by many investors, which bodes well for those who can spot an emerging growth opportunity and want to get in from the ground up.

Small-cap Challenges

The lack of transparency has tarnished the reputation of the small-cap segment. Information on many small-cap companies can be hard to find, especially for those stocks listed on the Bulletin Boards or Pink Sheets. This leaves many investors wary of the legitimacy and performance of some of these companies, and investors are often time stuck with many unanswered questions. But it's important to note that a lack of information doesn't necessarily equate to illegitimacy. Small companies may not have access to the capital needed to create and maintain an attractive and informative Web site, may opt to not spend the time and resources to fully report financials, and some haven't yet established effective public and/or investor relations campaigns.

Small-cap stocks also receive less analyst coverage than large caps, which reduces the stocks' visibility and credibility among investors who heavily weigh recommendations when deciding where to invest their money. Because of this, small companies not only miss out on the actual coverage, but also receive less brand promotion, which in essence can serve as a free advertisement. On the other hand, the stocks aren't subject to whipsaw trading at the mercy of a rating cut or other analyst action.

Large companies, due to their own recognizance, powerful PR tools, and sheer size, receive valuable media coverage that provide investors with pertinent information that sometimes cannot be dredged up by due diligence alone. The limelight can be a big payout, but it can also deepen damage in the event of a company crisis. Smaller companies facing a crisis can often clean-up the mess before the situation is broadcast to a broader audience.

Room to Grow

Investors like growth. And there's plenty of breathing room in the small-cap segment. Small companies experience higher average growth rates compared to larger ones as they launch new ideas and get a handle on unique and untapped niches. Often, the company is developing a proprietary product or service that hasn't yet reached its potential, and the company hasn't fully realized the various applications of the product. Growth is in the making.

Discovering these new applications often calls for continued product development, which can quickly result in additional growth and enhance value, making the company an attractive target for big companies seeking out merger and acquisition opportunities. Small-cap companies have nestled into niches that attract bigger companies looking for entrance opportunities and fresh ways to grow their own bottom line.

Many small-cap stocks have significant insider ownership, which demonstrates executive commitment to the company and creates an aligned interest with shareholders. If the company's management is willing to vest a personal stake in the company, it is more likely to earn the trust of outside investors as well.

As more of the business world picks up on the increasing and high-potential opportunities of the small-cap market, it becomes easier to find these stocks. There are hundreds of newsletters and small-cap-focused Web sites that constantly highlight emerging and established companies, though all sources are not to be trusted. The key for success in this market is a roving eye and proper due diligence, both of which can be strengthened by practice and enlightened market knowledge.

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