Are Investors Ignoring this Key Asset Class?

Justin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

There has been enormous hype this year regarding dividend stocks and with good reason.  Dividend paying stocks tend to outperform the S&P 500 by about a 1-2% over long holding periods.  With dividend yields on many blue-chips well beyond their respective bond yields, many have started to consider moving away from investment grade bonds in favor of their equity equivalents.  This is likely a prudent move for those that fully understand the increased volatility that will accompany such a move.  However, did you know that dividend paying stocks, as measured by the iShares Dow Jones Select Dividend ETF, have underperformed the S&P 500 by 4.5% this year?  This doesn’t change the favorable attributes and benefits to owing such securities, but it does demonstrate that the performance will zigzag over time.  Many have forgotten that.  It also begs the question as to whether investors have foolishly forgotten about another sector that has an equal, if not better, long-term track record than dividend paying stocks- SMALL-CAPS. 

Small-cap equities are an integral part of achieving market beating returns.  Unless you have recently been courted by the AARP, you should have a decent exposure to this asset class.  Adding dividend paying large-caps is great, but investors should be cautious doing so at the expense of this key investment class.  The history of small-cap performance relative to large-caps can best be summed up by one phrase- MEAN REVERTING.  Large-caps dominated the super bull market of the ‘80’s and ‘90’s.  Small-caps took the reins in 2000.  It is debatable as to whether this secular trend has shifted.  Large-caps beat small-caps, as measured by the S&P 500 vs. Russell 2000, by 6% in 2011 and hold a 2% advantage thus far in 2012.  So should investors continue to maintain a full weight to the small-cap space?

Are You Cautious on the Market? Favor Small-Caps

What periods were the best for small caps?  One would assume the high return periods in the market given their higher beta and growth potential.  However, small-caps have done better in low growth periods.  According to research by Royce Funds, small-caps outperformed large-caps in 95% of lower and normal-return periods from 1935 through 2011.  They used rolling ten-year average annual returns with quarterly endpoints.  The threshold for high growth, which favored large-caps 73% of the time, was an annual return on the S&P 500 in excess of 13.2%.  Why exactly this is the case is a bit of mystery to me, but it is none-the-less a compelling finding.  Maybe it has to do with the fact that small-caps are often ignored by the Wall Street community.  Therefore, they don’t’ have analysts covering them that can throw out exorbitant price targets to shoot for when markets are surging.  The classic example is the 1998 forecast by Henry Blodget for Amazon (NASDAQ: AMZN), a money-losing internet bookstore, to surge 67% and exceed $400.  It only took a matter of weeks for this forecast to be accurate.  Amazon has since become the dominate internet retailer, although the money losing hasn’t ceased entirely.  The company reported a 3Q12 loss of $0.60 per share, it first quarterly loss since the second quarter of 2003.  A second consecutive quarterly loss is a possibility and within the guidance range management provided. 

But Watch Out for Recession

Slower returns are good for small-cap relative performance, but recessions favor the defensive large-caps.  According to Ned Davis Research, small-caps underperform by about 6% around recession start dates.  According to the latest from ECRI, a new recession began around July of this year.  If they are accurate, investors should expect small-caps to suffer notable weakness.  While I give considerable merit to ECRI’s analysis, the missing link may very well be the performance of small-caps.  If the recession started in July, then small-caps should have underperformed large-caps by 5% during the last six months (historical average performance during the two months prior to a recession start date and four month into official recession).  Instead, the difference is less than one half of one percent.  In fact, small-caps have outperformed large-caps by almost two percent in recent weeks.

The Foolish Bottom Line

Small-caps remain a vital component in an investor’s portfolio and should not be forgotten.  Based on the above data, they may or may not outperform in 2013, but we can be certain they will outperform when holding periods extend beyond twenty years.  The small-cap advantages have persisted for decades.  The scant Wall Street coverage, which includes all of one analyst, has allowed Nortek (NASDAQ: NTK) stock to surge 150%.  Although a victim of the Global Financial Crisis, Nortek has emerged from bankruptcy to see its stock rise on the coattails of a housing rebound.  The company’s kitchen range hoods, exhaust fans, and home audio/security/display devices are all seeing prospects for improved demand. 

Small-caps can be acquired at huge premiums.  Look no further than McMoRan Exploration (NYSE: MMR) and the 80% surge in the stock price after Freeport-McMoRan Copper & Gold (NYSE: FCX) announced plans to acquire the company.  Freeport shared collapsed 15% on the takeover news!  With no synergies, investors in Freeport-McMoRan were forced to pay an 80% premium to the existing market price. 

The merits of small-cap investing continue to be the same now as it was fifty years ago.  Investors may be skittish about owning individual equities in the space as evidenced by Nortek’s bankruptcy experience.  This is why it is prudent to own a diversified basket of small-caps and take concentration risk with safer large-caps.  Remember there is an ETF for everything.  The iShares Russell 2000 Index ETF (NYSEMKT: IWM) is one such vehicle with deep liquidity. 

market8 has no positions in the stocks mentioned above. The Motley Fool owns shares of and Freeport-McMoRan Copper & Gold. Motley Fool newsletter services recommend Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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