When deciding on how much of your portfolio to dedicate to small-cap stocks, it’s important to note many of the perks that come along with buying smaller companies.
The most obvious advantage to small caps is their tendency to outperform their large-cap counterparts. In fact, according to a report from investment consulting firm Ibbotson Associates, small caps increased in value by approximately 12% between 1927 and 2007. During the same period, large caps only increased by 10%. A small cap stock generally has a market capitalization worth between $300 million and $2 billion. So while these companies are smaller than the titans, they are well-established and likely here to stay.
Let’s take a look at three key reasons to invest in small caps, with the corresponding evidence to support each claim.
Trading volume
Small caps generally have a low amount of trading because the stocks are much less well known by the investing community than large caps. This offers ample opportunity for savvy investors to purchase an undervalued stock before the masses realize its value.
It’s best to get in on these stocks when they have a trading volume between $50,000 and $500,000 per day. That means you’ll buy before the majority has had a chance to catch on to the stock’s potential.
With an average volume of about $400,000, Alliance Grain Traders Inc. (TSX:AGT) is in a solid position to profit from important company news when the masses get a hold of the information. And because Alliance Grain Traders Inc. (TSX:AGT) appears poised to profit from increasing global food demand, good news could be coming.
The company cleans, splits, sorts and bags specialty crops in the export market. That means the firm is poised to deliver the grains to the developing countries and their growing middle classes. Its profits are already soaring. Last month’s quarterly report noted the firm grew revenue to $276.4 from $197.4 in the first three months of fiscal 2012, compared to the first three months of fiscal 2011. The firm’s share price increased from nearly $12 to $14 in May, after the news that reached the masses who then wanted a piece of the action.
Less analyst coverage
When an analyst covering a small cap stock raises its ranking, the price is likely to go up. But because there are many analysts covering the same large cap, there is less of a corresponding influx in price.
Often, small caps only have one or two analysts covering them so when a stock is upgraded, expect big things ahead. For example, on April 18, DA Davidson upgraded Great Lakes Dredge & Dock Corporation (NASDAQ:GLDD) from a “Neutral” to a “Buy” rating. On the day after the development, the stock shot up nearly 7%. Despite operating at a loss of $3 million last year, and producing a mediocre year-over-year increases in revenue, the upgrade led many excited investors to purchase shares.
Great Lakes Dredge & Dock Corporation (NASDAQ:GLDD) has experienced solid revenue, but the expenses are sporadic, leading to a net loss last year. Even though the company’s financials are unattractive, just a bit of positive attention can set those who don’t do their own research on a buying frenzy. This shows that one person’s, or rating company’s, opinion is extremely powerful with small cap stocks, which can either be an advantage or disadvantage to shareholders. In this case, I anticipate Great Lakes Dredge & Dock Corporation (NASDAQ:GLDD)’ price dropping despite the upgrade it received from DA Davidson, due to the seemingly uncontrollable expense factor.
Acquisitions
Small cap stocks are often the topic of buyout talks.
One of the greatest investments I made was the purchase of MEDTOX Scientific, Inc. (NASDAQ:MTOX), which was a small cap formerly listed in the NASDAQ under the MEDTOX Scientific, Inc. (NASDAQ:MTOX) ticker. Laboratory Corp. of America Holdings (NYSE:LH) bought MEDTOX Scientific, Inc. (NASDAQ:MTOX), which triggered an increase in the stock’s price of about 25%. Laboratory Corp. of America Holdings (NYSE:LH) likely made the move to buy out the competition. The company is valued at about $9.2 billion, and is increasing revenue since the purchase. In fact, Laboratory Corp. of America Holdings (NYSE:LH) has increased revenue by nearly $1 billion in the last four years, and net income is a solid 10%. These numbers have been a consistent trend for the company, and appear to be the norm for the years ahead. If the firm keeps making smart purchases of small caps, there will be shareholder winners, such as those who owned MEDTOX Scientific, Inc. (NASDAQ:MTOX) at the time of its purchase.
Bottom line
While it’s clear that small caps can take your portfolio from being average to outperforming the S&P 500 (INDEXSP:.INX), it’s important to also anchor your holdings with large-cap stocks. Sure, the prices of small caps can increase substantially over a brief period of time, but they can also fall just as quickly. I generally keep about 60% of my portfolio invested in small caps.
Phillip Woolgar owns shares of 3D Systems. The Motley Fool recommends 3D Systems and Laboratory of America. The Motley Fool owns shares of 3D Systems and has the following options: Short Jan 2014 $36 Calls on 3D Systems and Short Jan 2014 $20 Puts on 3D Systems. Phillip is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
The article 3 Reasons Why Small Caps Rule originally appeared on Fool.com is written by Phillip Woolgar.
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