Thinking small

If your investment adviser has been telling you to save more for retirement, you should pay attention. Over the next few years a traditional stock or bond fund may offer you barely enough return to cover inflation.

So where should you go looking for investment opportunities instead? In my opinion, small capitalization stocks — typically those of young companies or small firms — are the most tempting alternatives out there.

I’m not the first person to make the case for small caps, of course. Since 2001, small caps have delivered an average annual return that is north of 15% in Canada and 13.5% in the U.S. But while the prices for these stocks have soared, I believe there is still some value left, especially if you’re thinking in terms of a multi-year investment and if you know where to look.

I base my case upon history. Small caps have almost always delivered better returns over the long term than large cap stocks or bonds — and right now large cap stocks and bonds are so expensive that their returns are likely to be dismal for the foreseeable future.

James O’Shaughnessy, the well-known U.S. investment researcher and money manager, presents the evidence for smallcap stocks in his new book Predicting the Markets of Tomorrow. Using historical data, he concludes that the average real return (i.e., what you make after inflation) from an index such as the S&P 500 that focuses on large companies is just over 7%. But here’s the catch: if the actual return from these large cap stocks exceeds 7% for a sustained period, it tends to be lower in subsequent periods, thus reverting towards the historical 7% average.

O’Shaughnessy argues that since returns from the S&P 500 far exceeded the 7% historical average during the Internet bubble, we are now in a correction phase that will drag down returns to the range of 3% to 5% over the next several years. Once you factor in the 2%-plus cost of management on a typical mutual fund, you’re left with a dismal return that won’t do much to make your retirement dreams come true.

For bonds, the picture is even worse. With bond yields currently around 4% a year, you make next to nothing in real terms after you subtract inflation of 2% to 3% a year and investment costs.

The case for small cap stocks, fortunately, is much better. Smaller companies have more room to grow than big firms. They’re more nimble as well, so they can move faster than their bigger rivals to capitalize on opportunities.

History demonstrates the payoff from those advantages. Since 1925, small caps have outperformed large caps by two to three percentage points a year with only brief periods of underperformance. After crunching all the numbers, O’Shaughnessy expects small caps to return in the range of 7.6% to 9.6% a year over the next 20 years.

If he’s right, the implications are enormous. Investors who stick to traditional large caps, bonds and cash assets will need to work much harder for retirement. Those who venture more aggressively into the small cap world can reap significant long-term benefits, provided they choose their investments wisely.

The first step in choosing wisely is assessing just how much of a bargain you’re getting. Where the buys on the next page summarizes the current situation and, at first glance, it seems to contradict much of O’Shaughnessy’s advice. As you can see, large cap stocks look like a better deal at the moment than small caps. You pay a lower price-to-earnings ratio (P/E) to buy large caps. You also enjoy lower management expenses and trading costs — yet the bigger stocks are less risky than their smaller counterparts when you measure their beta, or how much they move up or down in relation to the market.

Fortunately, you see a more attractive picture if you look only at the value component of the small cap universe. These stocks are slightly cheaper and slightly less risky than the overall small cap universe. My conclusion? If you’re going to make a bet on small cap stocks, concentrate on the relatively cheap, relatively undervalued end of the category.

I am not — repeat, not — inviting you to put all your money in small cap value stocks and ignore everything else. Diversification remains the best long-term strategy. However, a moderate bias towards the small-cap value sector can let you benefit from the long-term potential of this category, while alleviating concerns about current valuations.

In Small game hunters below, I have compiled a list of funds that specialize in the small cap area and that have a decent long-term record and a value bias. My list is not based on any rigorous quantitative approach. I have simply selected a handful of small cap funds that I like, because I am familiar with their history and style. So much the better if some of those funds have sagged for the past year or so: I know they will come back, because they always have in the past.

Where the buys are

Small cap stocks are now more expensive than large cap stocks. But bargain hunters can still find a deal if they focus on small cap value stocks.

Source: data compiled from information available in the public domain on ishares.com for the benchmark index funds of each style.
Source of estimated trading costs for each style is Harry S. Marmer’s book Perspectives on Institutional Investment Management.

Small game hunters

A few of my favorite small cap funds. All my chosen funds favor value picks.