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How to make money with small-cap stocks

Reprinted courtesy of MarketWatch.com.

To read the original article click here

Here’s one of Wall Street’s most poorly-kept secrets: Investors can make good money with the stocks of smaller companies whose names aren’t necessarily household words.

Ever heard of Alkermes PLC ALKS, -4.25% Cubist Pharmaceuticals (acquired by Merck MRK, -1.97%   in January for for $8.4 billion), or Packaging Corp. of AmericaPKG, -1.58% ? I didn’t think so. Neither had I, until I looked at a list of the largest holdings in Vanguard’s Small Cap Index Fund NAESX, -1.30% which represents the asset class known as U.S. small-cap.

I would never own those companies individually, but I’m perfectly comfortable holding them as part of a fund portfolio with thousands of stocks.

(The Vanguard fund’s top holdings also include some more familiar names: Alaska Air Group ALK, -1.41% Rite Aid RAD, -0.39%  and Goodyear Tire & RubberGT, -1.24% to name just three.)

Like value stocks, small-cap stocks are an essential part of a well-diversified equity portfolio. Let’s look at some of the data behind that assertion.

From 1928 through 2014, U.S. small-cap stocks turned in a compound annual return of 12.2% (compared with 9.8% for the Standard & Poor’s 500 Index SPX, -1.42% ).

At 12.2%, an investment of $100 would have grown to $2.2 million over those 87 years (compared with slightly less than $350,000 for the S&P 500).

However, on the way to that fine long-term performance, small-cap stocks gave investors a bumpier ride. Although the average one-year return for this asset class was 16%, there was one year (1933) when small-cap stocks more than doubled (up 110%) and another when they lost 48% (1937).

Of the individual years, 59 produced gains (averaging 31.2%) and 28 produced losses (averaging 16%). Statistically those are mighty good odds — at least if you are willing to lose nearly a third of your money in a 12-month period.

But it would be a rare investor indeed who could set money aside and let it grow for 87 years.

A more realistic period for many investors (perhaps for most investors, if you include retirement) is 40 years. The 1928-2014 data includes 48 such periods.

In every one of those periods, the small-cap index returned more than 10%. The lowest 10-year compound return was 10.7%; the highest was 16.7%.

You might think those two periods would be made up of quite different years, but it’s not so. The best period started in 1975; the worst started only six years earlier, in 1969. This is evidence that luck — the precise time when you first invest — can play a big role in your outcome.

Most investors evaluate performance over periods of less than 40 years, of course. So I obtained the numbers for all the 15-year periods from 1928 through 2014 — there were 73 of them.

On average, small-cap stocks returned 13.8% during those 15-year periods. But there were significant variations. The best 15 years, starting in 1975, produced a compound return of 23.1%; the worst, starting in 1928, resulted in a compound return of only 1.6%.

That sounds bad, I know. But it means that, for most of a century, small-cap stock returns were positive in every 15-year period. Indeed, the period starting in 1928 was one of only nine that produced compound returns less than 10%. (The average return of those nine periods was 6.2%.)

In the other 64 periods, returns were above 10% — with an average gain of 14.9%.

Maybe that’s enough numbers for now.

It’s not hard to understand why small companies can make good investments: They have lots of room to grow. Google was once a startup, as was Apple. The same is true for every corporate giant.

Only a very few make it into the Google-Apple league, and it’s impossible to know in advance which ones will make the grade. But if you invest in hundreds of small-cap stocks, you will have a piece of the action when the next obscure idea suddenly explodes with success.

Should you invest your money exclusively in small-cap stocks? Not on your life!

But I do think that small-cap stocks should make up a significant part of your equity portfolio.

In the next article in this series, I’ll describe an even more interesting asset class: Small-cap value stocks. These, as you might surmise are stocks of companies that are both small and out-of-favor with investors enough to qualify as value stocks.

In the article after that, I will show you how, without even venturing into international investing, you can put together a four-fund equity portfolio that historically has outperformed the S&P 500 by more than two full percentage points, with very little additional risk.

Before I leave the topic of small-cap investing, I need to cover a little bit of fine print. Size does indeed matter here, and there are varying definitions of what is small-cap and what is midcap.

The numbers I’ve used are from an index created by Dimensional Fund Advisors. The average market capitalization of companies in this index is $1.6 billion. That is considerably lower than some other measures of small-cap investing.

In Vanguard’s excellent small-cap index fund, for example, the average company has a market capitalization of $2.9 billion.

Here’s what that means: In years when smaller stocks are more productive than larger ones, the DFA index will most likely show higher returns than the Vanguard fund. But in years when large cap beats small cap I would expect the Vanguard fund to do better than the smaller small-cap fund from DFA.

For more on small-cap investing, check out my podcast, 10 things you should know about small-cap funds.

Richard Buck contributed to this article.