Here’s Why All Investors Should Own Some Small Cap Stocks

penny stocksFrom Grant Wasylik: Far too many investors ignore small-cap stocks, and that’s more likely than not to hurt their portfolio’s returns.

Do you own any stocks with market capitalizations under $300 million, $500 million or $1 billion?

If not, you’ve been missing out.

Here are five important reasons why microcap stocks warrant a piece of your asset-allocation pie.

No. 1: Microcaps outperform their bigger-cap pals (small- and large-caps) over the longer term.

Microcaps outperform in long-dated, high-return cycles … long-dated, low-return cycles … and over the long term, in general.

Source: Ibbotson Classic Yearbook, 2015

Let’s translate this outperformance into dollars. Just $1 invested in each of three market-cap slots over the last 90 years (12/31/1925 to 12/31/2015) would amount to:

  $5,376 for large-caps,

  $17,146 for small-caps, and

  $28,831 for microcaps!

No. 2: Generally, microcaps are off Wall Street’s radar.

Wall Street doesn’t want to waste its time reporting on little companies. That means plenty of neglected opportunities exist in this part of the market.

Source: Furey Research Partners, March 2016

Stocks with market caps of less than $3 billion attract just 9% of analysts’ coverage.

If you go below the $300 million market cap, analyst coverage is a miniscule 2%.

No. 3: Microcaps have the highest degree of insider ownership.

When insiders own big stakes of a company, they have their own monetary incentives at stake.

So, not only are they trying to create long-term value for investors … but, they also want to pad their own wallets. High insider ownership means the interests of company management and investors are aligned.

Source: Furey Research Partners, March 2016

Various studies have shown that stocks with high insider ownership perform better than stocks without such ownership. Microcaps and small-caps possess a sizable advantage in this area.

No. 4: The highest probability of takeovers happens at the microcap level.

Bigger companies buy smaller companies. So, the following chart should make sense …

Source: Furey Research Partners, March 2016

Over 60% of public M&A deals occurred at the microcap level (below $300 million market cap). And more than 90% of public M&A deals took place in the microcap and small-cap space (below $3 billion market cap).

This means it’s wise to hunt for takeover candidates in smaller-capitalization stocks.

Typically, takeovers result in big paydays for shareholders. Barron’s calculates an average acquisition premium of 24% from 1984 to 2013. And FactSet reports a median takeover premium of over 30% in the last two years.

No. 5: Microcaps offer portfolio diversification.

Microcap stocks have low correlations to other asset classes. Correlation measures the relationship between two different asset classes under the same market conditions.

Source: FactSet

Microcaps and smaller-cap stocks — with their lower correlations — make good diversifiers.

OK, those are five main reasons you should consider carving out a small piece of your asset allocation framework for microcap stocks.

It’s also worth noting there are two other reasons to own smaller-sized stocks in the current market environment. First, microcaps perform better than other capitalization stocks in low-growth environments (like we’re in now). And second, smaller-cap stocks perform well after rate hikes (a future rate hike(s) will come at some point).

Remember, sometimes, it pays to think small.

For investors not comfortable with owning single small-cap stocks, the iShares Russell 2000 Index ETF (NYSE:IWM) is an attractive option as well. The IWM has risen 10% year-to-date, outperforming the S&P 500 in the same period by a full two percentage points.

This article is brought to you courtesy of Uncommon Wisdom Daily.

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