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Don’t Let Small Company Stocks Pass You By


By , with Annuity FYI

Don’t let headlines mask the market’s real stars. This year, they are small public companies, not giant corporations. As the stock market once again closes in on new records, annuity owners with non-annuity stock market investments should take a moment to consider which stock indexes are grabbing virtually all the attention. They are the indexes of big stocks, mostly the Dow Jones Industrial Average and the S&P 500.

(Editor’s Note: This article, originally posted in 2018, was prophetic, and the information it provides remains valid. The key take-away is that small stocks return an annual average of about two percentage points more than large stocks over time, mostly because small companies tend to have more growth potential than big companies. 

For a while, big stocks were beating small stocks post-2018, but they have moved back to the front over roughly the past year. The Russell 2000 index of small-cap stocks ended June 2021 with its ninth consecutive month of gains. That was its longest monthly winning streak since December 1986, according to Dow Jones Market Data. The index advanced 49 percent since the end of September 2020, when Covid-19 vaccine trials inspired confidence about continued economic growth. In the same period, the S&P 500 benchmark of large-cap U.S. companies rose 30 percent. The Russell also outpaced the S&P 500 in 2020.

A strong economic recovery should continue to support superior small cap performance because these stocks are more sensitive to the rebounding U.S. economy. They’re highly likely to repeat their winning 2020 performance in 2021 because of the potential for more fiscal stimulus and a continued strong economic recovery. Much the same can be said about 2022.

Small stocks do tend to be riskier than big stocks, especially when the economy softens, because small companies can’t rival big company financial resources. A tough new competitor, for instance, could be devastating. Nonetheless, a sizable basket of small cap stocks largely offsets this risk.)

Don’t let headlines mask the market’s real stars. This year, they are small public companies, not giant corporations

As the stock market once again closes in on new records, annuity owners with non-annuity stock market investments should take a moment to consider which stock indexes are grabbing virtually all the attention. They are the indexes of big stocks, mostly the Dow Jones Industrial Average and the S&P 500.

Yet it is small stocks—specifically, the Russell 2000 – that are on the biggest roll of all in aggregate and may be embarking on a new bullish trend with legs after a multi-year lull.

Some exchange-traded funds and mutual funds cater to these and perhaps should be part of your stock market investment strategy. In the first half of 2018, the Russell 2000 beat the S&P 500 by almost five percentage points. Stocks in the Russell 2000, which have an average capitalization of $2.3 billion, may continue to outperform their bigger brethren – and not just because small cap stocks outperform and underperform big stocks in cycles and are only in the early stages of outperformance.

In particular, a big plus for small cap stocks these days is that, unlike big stocks, their business is mostly U.S.-centric, enabling them to sidestep a budding tariff war, especially with China. In addition, the U.S. economy today is unusually strong– certainly much stronger that most of the rest of the industrialized world. The U.S. economy isn’t expected to again generate the 4.1% growth rate it posted in the second quarter, but the odds nonetheless strongly favor an above-average performance at least through year-end.

Small stocks also make sense for buy-and-hold investors. Over a long span of time, they have returned an annual average of about two percentage more than large stocks, mostly because small companies tend to have more growth potential than big companies.

To be sure, small stocks tend to be riskier than big stocks, especially when the economy softens, because small companies can’t rival big company financial resources. A tough new competitor, for example, could be devastating.

Nonetheless, a sizable basket of small cap stocks largely offsets this risk and the unvarnished truth is that risk-averse investors can seldom reap superior returns.

There are additional reasons why investors should consider small stocks today.

They include:

  • Small stocks are often under-recognized. As a rule, they attract minimal Wall Street attention. This enhances the odds of improper stock pricing, and stocks tend to benefit from market inefficiencies over time.
  • Most mutual funds don’t invest in small stocks because good performance has minimal impact on their portfolio. This enables individual investors who can spot promising companies to buy the stock before institutional investors. When institutions follow, that usually pushes up the stock.
  • Small stocks are unlikely to rival the super-charged performance of technology behemoths Amazon, Alphabet (the parent of Google) or Apple, but they often reflect young companies with greater growth prospects than most big, mature companies. Most successful giants were small caps in the beginning with impressive new products and services. Small companies also offer investors promising prospects because it’s easier to grow from a small base.
  • Small companies in general benefit more than big companies from the Trump administration’s tax cuts in 2017. Tax cuts for corporations, big and small, were cut from 35% to 21%. When they were higher, small companies generally didn’t have the wherewithal to employ tax attorneys to legally skirt paying the top rate. In addition, small, domestic companies don’t have subsidiaries in low-tax countries such as Ireland, Panama and the United Arab Emirates.

On the negative side – again – is heightened risk. While small companies do have superior growth potential, they largely have no choice but to scale their business model to generate sufficient cash. In addition, they tend to have smaller customer bases and smaller balance sheets and thus less insulation from weak economic conditions. Small caps are also more susceptible to volatility because it takes less trading volume to impact prices.

How can prospective investors find the right small stocks?

They could do their own research, but that is a lot of work and available Wall Street research is limited. Investors are probably better off considering the purchase of shares in exchange-traded funds or mutual funds such as the iShares Russell 2000 index, Vanguard Small-Cap, Schwab U.S. Small-Cap, Fidelity Small Cap Stock, or Conestoga Small Cap Investors.

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