Finding Value in Small Cap Stocks

The argument for smaller companies used to be simple: Their shares are riskier, on average, than shares of larger companies, but they return more to investors. So, more risk, more reward, asserts James K. Glassman, Kiplinger's Personal Finance.

One advantage of a stock with a small market capitalization (defined as price times shares outstanding) is that, being small, it may elude the attention of analysts and most investors. Such a stock can be an overlooked bargain. Another plus: you have a chance to make gigantic returns on your original investment. For example, if you bought Netflix in 2008 when it was a small-cap stock trading at about $4 a share, your investment would now be worth about $495 per share.

Despite their benefits, large-cap stocks have beaten small caps in five of the past six full calendar years since 2014 – and so far in 2020, it has been a massacre.

Investors, naturally, are turned off. But if you still seek value among sectors that are out of favor, you may find it hard to resist small caps right now.

Why have small caps suffered so much lately? One theory is that investors have driven down their relative prices by favoring index funds geared to the “market,” which typically means the S&P 500, representing about four-fifths of the value of all listed U.S. companies.

Another explanation is that a small group of mega-cap stocks, including Apple and Amazon.com, have sucked up so much investing oxygen that small caps were left gasping for breath. A third explanation: To compete in today’s globalized economy, you need to be big. Small companies are simply at a disadvantage.

But many individual small-cap stocks are hidden gems. They’re not easy for individual investors to analyze, but a solution is to buy actively managed small-cap funds with records of successful stock picking. These funds tend to have high fees, and some of the best of them are often closed to new investors.

Here are three to consider: Wasatch Ultra Growth (symbol WAMCX), with a lofty expense ratio of 1.24%. But, in this case, you get what you pay for. The fund, which owns 80 stocks and has a relatively low turnover rate, boasts an average annual return of 23.5% over the past five years.

Buffalo Small Cap (BUFSX), co-managed by Robert Male for the past 22 years, has a five-year average annual return of 15.9%. It had a spectacular year in 2019 and as of early August has returned 27.2% in 2020, more than 30 percentage points ahead of the small-cap indexes. The fund is heavily invested in health care stocks.

Another fund led by a long-term manager, Conestoga Small Cap (CCASX), has scored an annual average return of 15.0% over the past five years by concentrating on industrial stocks.

Editor’s Note: James K. Glassman is a contributing columnist to Kiplinger’s Personal Finance magazine, www.Kiplinger.com.