Big Opportunities in Small-Cap Stocks

This article first appeared in the February/March 2011 issue of Morningstar Advisor magazine. Get your free subscription today!

In 2010, the Morningstar Small Cap Index outperformed the Morningstar Large Cap Index by more than 10%. This added to an already long streak of outperformance by small-cap stocks. Small caps have outperformed over the past one-, three-, five-, and 10-year periods. During the past 10 years, small caps have crushed large caps by more than 7% per year on an annualized basis. With no signs that this trend is going to reverse in the near future, we thought it would be worthwhile to scan for some small-cap investments.

Equity Style Box = Small

First, we searched for stocks that fall into the small-cap bucket. Small-cap stocks have a number of advantages over larger stocks. One of the benefits is the ability to grow sales at faster rates. It is a lot easier to increase revenue at high growth rates when a company is only doing $300 million in sales than when it is doing $30 billion. The smaller size of operations also allows small businesses to more quickly adapt and change strategies in response to a changing industry. With smaller stocks, firms also have the extra upside potential from the possibility of being acquired. Although we do not encourage blindly speculating on takeover candidates, if we find companies that we are happy to own as stand-alone businesses, the chance of a takeover is an added bonus.

Of course, all of these benefits must be weighed against the negatives of small-cap stocks, such as fewer scale advantages, less-diversified business operations, and so on.

And (Moat Rating = Narrow
Or Moat Rating = Wide)

When investing in small-cap stocks, it is important to find companies with moats. If a company does not have a competitive advantage, it will not be able to hold off larger competitors for very long. Bigger companies have greater scale and more resources, so they will likely be able to compete in the same market more profitably than a small company. The moat will help fight off competition from larger businesses.

Moats are also important if you are looking for buyout candidates. Most companies would prefer to expand internally, rather than paying a premium to acquire a competitor in order to enter a market. If a small-cap company has an economic moat (whether that is patents or a strong brand) it has something that a competitor can't create on its own.