Small-Cap Stocks Defined

"Cap" refers to the market capitalization of the company issuing stock. The company’s total market capitalization includes the value of stock and debt outstanding. Although definitions of what constitutes "small" cap can differ, a commonly used benchmark for small-cap funds, the S&P SmallCap 600 Index, includes companies with capitalizations less than $1 billion.

Many smaller companies serve niche markets with steady consumer demand for their products and services, or emerging industries with the potential for substantial future growth. Such companies may experience above-average earnings growth or have earnings that are less susceptible to changes in the overall economy. On the other hand, the smaller capitalizations of these companies can make it harder for them to sustain a business downturn. Also, they tend to have more bank debt relative to total capital than do larger firms, so profits of some smaller companies may be sensitive to rising interest rates.

Small-Cap Stocks: Some Pros And Cons

Although large-cap stocks were generally the top performers in the late 1990s, historically, small-cap stocks have outperformed the overall market, and have outperformed since 2000.** Over time the difference has been dramatic. For the 50-year period ended December 31, 2007, $1.00 invested in large-cap stocks would have grown to $184; the same investment in small-cap stocks would have grown to $532.*** This past performance does not guarantee future results.

Small companies typically do not pay dividends. They also are more thinly traded than stocks of larger companies. These factors tend to make small-cap stocks more volatile than large-company stocks. While the purchase or sale of 10,000 shares would have little effect on the price of a blue chip stock, it could have a major impact on a smaller company with a similar share price.

**Source: For the 50-year period ended December 31, 2007. Sources: Center for Research in Securities Prices, University of Chicago 1957-1993; Standard & Poor’s, 1957-2007. Large-cap stocks are represented by Standard & Poor’s Composite Index of 500 stocks, an unmanaged index considered representative of the U.S. large-cap stock market. Small-cap stocks are represented by the Center for Research in Securities Prices 6^th-8^th Decile of New York Stock Exchange from 1957 to 1993 and the S&P SmallCap 600 Index from 1994 to 2007, unmanaged indexes. Past performance cannot guarantee future results. Individuals cannot invest directly in any index.

***For the 50-year period ended December 31, 2007. Sources: Center for Research in Securities Prices, University of Chicago 1957-1993; Standard & Poor’s, 1957-2006. Large-cap stocks are represented by Standard & Poor’s Composite Index of 500 stocks, an unmanaged index considered representative of the U.S. large-cap stock market. Small-cap stocks are represented by the Center for Research in Securities Prices 6^th-8^th Decile of New York Stock Exchange from 1957 to 1993 and the S&P SmallCap 600 Index from 1994 to 2007, unmanaged indexes. Past performance cannot guarantee future results. Individuals cannot invest directly in any index.

Average Annual Rates of Return

The Small-Cap Premium Potential

In the 1970s and early 1980s small-cap stocks provided returns greater than would be expected from basic risk and return calculations. This excess return has been termed "the small-cap premium," an extra return earned by small-stock investors.

A theory for the excess returns small-cap stocks earned in these years is known as "the neglected-firm effect." If General Motors announced a merger it would be front-page business news around the world, but the day-to-day activities of small businesses often go unnoticed. Another explanation is that institutional stock analysts, people who track investments for the major investment banks, mutual funds, and pension plans, are primarily focused on larger companies.

Small-Cap Stocks And Diversified Portfolios

Small-cap stock returns tend not to move in lockstep with stocks of larger companies. Instead, small-cap performance has tended to lead or lag that of larger companies for periods of several years. Given such cyclical differences, small-cap stocks have offered investors an opportunity to help manage the overall risk of a portfolio of large-company stocks by including a small-cap component.

This potential for lower volatility combined with higher return potential is a primary reason suitable long-term investors may want to consider investing a portion of their portfolios in small-cap stocks.

Small-Cap Investment Strategies

Investing in individual small-cap stocks can be difficult for the individual investor. Small-cap stock picking is often more difficult due to a lack of readily available company-specific information. Higher transaction costs and higher risks associated with small-cap stocks are additional barriers. Investors can help manage liquidity risk by looking for stocks with a weekly trading volume of at least 60,000 shares. Companies that you know and that have a competitive record of steady profits and financial strength may be less risky.

Small-Cap Stock Funds

Some so-called small-cap funds also invest in stocks of larger companies. One reason is that once a small-cap fund grows beyond a certain size, it begins to run out of companies to invest in, as the universe of small-cap stocks is relatively tiny when compared with the size of the market. Also, the recent bull markets have added to the size of many so-called small firms. For instance, the average market cap of companies in the S&P SmallCap 600 Index escalated from $250 million in 1994 to $708 million in 2007, according to Standard and Poor's. Lastly, since mutual funds are limited in the percentage of a company’s shares they can own, and since not all small-cap stocks are considered attractive investments, it doesn’t take long before a large mutual fund is saturated in its small-cap exposure. So don’t be surprised to find some mid-cap and large-cap stocks in your small-cap fund.

Mutual funds offer diversification and professional analysis and management as an alternative to picking individual stocks. Index funds strive to mirror the returns of a benchmark such as the S&P SmallCap 600. Other small-cap funds attempt to pick individual stocks within that universe to enhance fund performance. In either case, you should realize that benchmark indexes like the S&P SmallCap 600 are unmanaged and they do not reflect transaction costs.

Points To Remember

1. Small-cap stocks can help diversify portfolios.
2. They also carry a higher risk of price fluctuations.
3. While definitions vary, small-cap stocks are generally considered to be those with capitalizations less than $1 billion.
4. Small-cap stocks do not move in lockstep with the overall market. Investors can increase the diversification of their portfolio and potentially help manage risk by including small-cap stocks.
5. Some small-cap mutual funds may also be invested in large-cap stocks because of limited investment options as a fund grows in size.
6. Mutual funds provide a means for the individual investor to more easily invest in small-cap stocks.