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By (Almost) Any Measure, Small-Cap Stocks Beat the Market

As in most time periods, small-cap stocks have beaten the market in 2016. And here’s the kicker: they’re not as risky as some analysts would have you believe.

The vast majority of investment advisors say that small-cap stocks carry more risk than large caps. But that over the long-term, the additional risk can be well worth it since small caps tend to outperform by a significant margin.

I think that’s good advice. But we need more details to round out the discussion. How much more risk do small-cap stocks carry? By how much do they outperform? How do I invest? These are basic questions that I suspect many advisors don’t have quick answers to. But I do.

Over the last 20 years, small caps have outperformed large caps by 244%, delivering a total return of 472%.

That’s eye-catching outperformance! But to be fair, many investors don’t want to wait 20 years. So a 10-year timeframe is worth a look. Over a 10-year period, small caps have outperformed by 35%, delivering a total gain of 103%.

Still, 10 years is a long time. Seinfeld only ran for nine! So for the very short-term oriented, let’s take a look at year-to-date returns. Again, small caps lead, but by a slighter margin of 4.5%, posting year-to-date gains of 11.3%, versus 6.9% for large caps.

Obviously there are timeframes over which small caps have underperformed and/or delivered a negative return. You can pick any date you wish to analyze. For simplicity’s sake, I’ve assembled calendar year returns since the last recession. In five of those eight years, small caps outperformed, and delivered positive returns. In two, they fell and underperformed. And in one they rose, but large caps did better.

That handles the relative performance question. Next, the risk question. I suggest looking over the charts above and noting the relative pops and drops in the green lines (small caps) versus black lines (large caps). That will give you some indication.

A more scientific approach is to compare the S&P 600 index’s beta with that of the large cap index (I do this using the respective ETFs). Beta measures how closely a stock or ETF is correlated with the market (the S&P 500). A beta of 1.0 means the stock tends to move the same amount as the broad market, whereas a beta over 1.0 means the stock moves more. The amount of relative movement depends on how much the beta is above or below 1. For instance, a beta of 1.1 implies that a stock would move about 10% more than the market. Beta is typically measured over a period of months or years to smooth out daily volatility.

Over the last three years, small caps have had a beta of 1.03. That means they’ve moved around 3% more than large caps. Over the last 10 years, that beta increases to 1.15. So yes, small-cap stocks move around more—but not insanely so. And I’d argue those comparatively larger dips can be a good time to jump into small-cap stocks and capture the comparatively larger rally that generally follows.

All Small-Cap ETFs are Not Created Equal

So what do you buy?

By far the easiest way is to invest with small-cap ETFs. Many online brokers allow you to buy and trade small-cap ETFs with zero commissions. And instant diversification of an ETF is very attractive to those who lack the interest to buy individual stocks.

But be aware that all small-cap funds are not created equal.

There are significant performance differences between small-cap ETFs. The example I always give is to juxtapose the Russell 2000 Small Cap ETF with the S&P 600 Small Cap ETF. The Russell is widely viewed as the benchmark index for small-cap stocks, but the less-followed S&P 600 Small Cap Index is arguably the superior index. When it comes to performance, there doesn’t appear to be any comparison.

Data from Index Fund Advisors shows that the S&P 600 outperformed the Russell 2000 by 1.8% annually for 20 years.

The time period studied was from 1994 to 2013, and the S&P 600’s average annual gain was 11.1%, versus 9.3% for the Russell 2000.

Assuming a $10,000 investment, the extra performance of the S&P 600 generated $17,654 more in capital gains, for a total return of $81,353. Shorter time periods show similar outperformance.

There are reasons why the S&P 600 tends to outperform. The Russell lacks a fundamental screen—it is simply the 2,000 smallest stocks among the 3,000 largest stocks in the U.S. stock market. In contrast, the S&P 600 Index has a profitability screen.

Companies must have posted four consecutive quarters of profits to be included. And there is no annual reconstitution with the S&P 600, so traders can’t game the index. Additions and deletions to the S&P 600 are decided by a committee.

There are ETFs that track both indexes, so in my mind there is absolutely no reason to buy the Russell 2000. Instead, I always recommend investors buy the iShares S&P Small Cap 600 ETF (IJR).

How Interest Rates, M&A Activity and GDP Affect Small Caps

There are a few big picture considerations you should ponder if you’ve yet to jump into small-cap stocks.

First, there has historically been weakness in stocks, including small-cap stocks, following the Fed’s first rate hike. But that event is already behind us (assuming the Fed continues to increase rates). And 40 years of research show that rising rates have actually been good for small caps, not only in absolute turns (generating higher returns than in falling rate environments) but also in relative terms (generating higher returns than large caps). Data from Fidelity dating back to 1979 shows that small caps have enjoyed an average 12-month gain of 14% to 15% when both short and long-term rates rise by around 1%.

Another part of the current small cap attraction is M&A activity, especially in small and mid-cap technology stocks. Over the past few months, mergers or all-out acquisitions have led to big overnight gains in LogMeIn (LOGM), NetSuite (N), Demandware (CRM) and Textura (ORCL), among others. I am confident there will be more.

U.S. GDP expansion also provides an excellent backdrop for small-cap stocks given that around 80% of small-cap sales come from within the U.S. Expansion leads to revenue and earnings growth, which are the main drivers of growth stock appreciation. During economic expansions, the average 12-month rise in small caps is 21%, versus 4.8% during economic contractions, according to Fidelity.

The bottom line is that small-cap stocks tend to outperform over the long-term. However, anyone who’s interested in buying individual small-cap stocks should get help from somebody who follows the asset class closely and can suggest names that should do much better than the small cap index. Each stock in our portfolio has a good chance to lead the market in the months ahead. We’re seeing double-digit gains in our stocks within weeks, and my last three recommendations are up an average of 43%!

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Tyler Laundon is chief analyst of the limited-subscription advisory, Cabot Small-Cap Confidential and grand slam advisory Cabot Early Opportunities. He has spent his entire career managing, consulting and analyzing start-up and small-cap companies. His hands-on experience has taught Tyler that the development of a superior business model is the biggest factor in determining a company’s long-term success. Accordingly, his research focuses on assessing the viability of management’s growth strategies, trends in addressable markets and achievement of major developmental milestones.