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Sizing Up Small Cap Stocks

By Jason Ronovech
Equities
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  • Small capitalization, or “small cap”, stocks represent the smallest 10% of the capitalization of the U.S. equity market, which includes companies with market caps to about $2 billion. 
  • Small cap stocks have generated attractive investment returns over the long term, but come with greater risks to consider. 
  • Less analyst coverage, low liquidity, capacity constraints, and volatility may account for the sources of greater potential return as well as risk. Thorough fundamental analysis may allow investors to uncover inefficiencies imbedded in small cap stocks, although information is not as readily available as with large cap stocks.

Small Cap Stocks Defined

Morningstar’s classification system divides equities into three capitalization categories – large cap, mid cap, and small cap. Large cap stocks represent stocks in the largest 70% of the U.S. equity market, and mid cap stocks represent the next 20%. The remaining 10% of the capitalization of the U.S. equity market are known as small cap stocks. 

The small cap segment includes companies with market caps up to around $2 billion. While at the bottom 10% based on capitalization, the number of total companies that fall in this category is actually significantly larger than the total number of companies in the large cap and mid cap categories combined. 

While it is inferred that small cap companies have market values that fall on the lower end of the spectrum of publicly traded companies, small cap companies can also be emerging growth companies, have significant share of niche markets, or niches in large but highly fragmented markets.

What Makes Small Caps Attractive?

As can be observed in the chart below, small cap stocks have generated attractive investment returns relative to certain other asset classes and stock market capitalization segments over time.

Investment Growth of $1

 
Return Summary (1/1/1926 to 6/30/2019)
  Cumulative Return Annualized Return
IA SBBI US Small Stock 3,674,605.33% 11.90%
IA US Large Stock  833,267.17% 10.14%
IA SBBI US LT Government  15,455.83% 5.55%
IA SBBI US 30 Day T-Bill  2,041.79% 3.33%

Source: Ibbotson Associates data

What Are the Drivers of Small Cap Returns?

Startups that haven’t attracted significant capital yet or are just beginning to gain traction may standout as good buyout candidates to larger organizations. While this alone can be a source of significant alpha in a small cap portfolio, we believe research inefficiencies within the asset class offer the most compelling investment opportunities. These inefficiencies are due to several factors. 

One, there is a lower than average number of analysts on the “sell-side” that write research reports on these companies compared to large cap companies. The average large cap stock is followed by over 20 analysts, while the average small cap stock typically has less than 10. In fact many small cap companies have zero research coverage due to the high volume of companies of this size. 

Another inefficiency is that fewer investment managers devote research resources to analyzing small companies. In addition to the high number of small cap companies, other potential hurdles such as less trading liquidity or shorter track records to substantiate their business models can inhibit research efforts.  

A third efficiency factor that could make small cap stocks attractive investments is the volatility of their stock prices. Lower liquidity of small caps creates a supply and demand scenario that can cause large swings in share prices given sudden changes in sentiment. This presents significant opportunities for active managers to capitalize with their stock selection. Active portfolio management also presents the opportunity for diversification to minimize stock-specific volatility and risks. 

Summary

Small cap stocks can generate attractive long-term returns but come with embedded characteristics that increase their risk profile. We believe careful fundamental analysis is necessary to:

  1. Recognize acquisition potential 
  2. Identify and capitalize on inefficiencies
  3. Reduce the downside volatility

About the Author

jason ronovech

Jason Ronovech

Senior Portfolio Manager
Jason is Vice President, Senior Portfolio Manager for the Small Company Equity strategy. He received a BA from Hamilton College and holds the Chartered Financial Analyst (CFA) designation.  
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Discover How Fort Washington Uncovers Inefficiencies in Small Cap Stocks

Explore our latest white paper for a more detailed look inside small cap investing. Employing its methodology since 2013 under the leadership of Senior Portfolio Manager Jason Ronovech, CFA, the Fort Washington Small Company Equity strategy has regularly outperformed the Russell 2000 Index with lower downside volatility.
IMPORTANT DISCLOSURES
Past performance is not indicative of future results.  This publication contains the current opinions of Fort Washington Investment Advisors, Inc. Such opinions are subject to change without notice. This publication has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. Fort Washington or its affiliates may from time to time provide advice with respect to acquiring, holding, or selling a position in the securities mentioned herein. Information and statistics contained herein have been obtained from sources believed to be reliable but are not guaranteed to be accurate or complete. No part of this publication may be reproduced in any form, or referred to in any other publication, without the express written permission of Fort Washington Investment Advisors, Inc.