The Future of Small-Cap Stocks

I recently had the opportunity to talk to one of ours editors who you don’t hear from regularly in Cabot Wealth Advisory, Thomas Garrity, editor of Cabot Small-Cap Confidential. Today I’ve got a Q&A to share with you about why Tom prefers to invest in small-caps, what he thinks the best investment strategy is now and in the long-term. I hope you enjoy it! (Interesting side note: The Russell 2000 index of small-cap stocks pushed above the 50-day moving average on December 17–the first time since the market collapse began in September.)

Question: Tell me how you got into investing, specifically small-caps.

Answer: My curiosity for investments goes back to my grandfather’s and my father’s influence in my early years. My passion for investment research took on scope and meaning when I was working part time in college. My grandfather planted the seeds for work ethic in me, as he grew up an orphan and through hard work managed to own a seat on the NYSE. My dad played an equal role, imparting his knowledge by reminiscing about his days working as a chartist. So you might say that stocks are at the core of who I am; they’re in my genes.

My selective involvement for investing in small-cap stocks originated out of necessity, as college kids are often broke, combined with a desire to capitalize on the efficient market theory. I was looking to find a 10-bagger stock in an effort to refute the theorem that all information relevant to security pricing is known. How could stocks reflect the full extent of information that can be acquired when all the facts aren’t in usable form? Needless to say, I had a difference of opinion with the philosophy that stocks fully discount the future. But what’s a college kid to do, re-write the finance text? My best strategy was to take advantage of the information gap and the best place to start was in the small-cap arena.

As an investment, small-capitalization stocks represent an entire class that, over the years, has been ostracized and entirely overlooked, primarily on the basis of information scarcity, in favor of mid- and large-cap stocks. The latter group was the favorite then and is today the preferred capitalization investment choice by the financial community as a whole. So I reasoned, investing in small-caps would immediately give me a few extra steps out of the starting gate simply because they were being ignored.

Second, I had limited funds to deploy so if I could buy 50 shares of XYZ company at 2.00 versus one share of IBM at 100, I’d have some additional price leverage. Finally, I didn’t want to risk a lot of money by investing in the wrong horse, I only wanted to make a lot of money. After all, I’d heard stories from my grandfather about the stock market crash in the 1920s and I knew that investing in stocks would be a risky enterprise.

Despite the ambiguity that comes from treading into uncertain waters, my first investment in a small-cap stock worked flawlessly and I was able to make a quick 50% on my invested capital. My initial experience investing in small-caps, more than a quarter of a century ago, has never been forgotten. I was hooked on small-capitalization investing.

Question: Why do you prefer to invest in small-cap stocks? What benefits do they offer investors?

Answer: The obvious reason for investment in small- and micro-cap stocks would be that they have a proven and long history of outperforming all other asset classes. The last statistics I saw on the performance of small-cap stocks showed that during a 79-year period, returns on small-cap and micro-cap stocks have outperformed large-cap stocks by 165% and 437% respectively.

The second reason may sound a little silly, but I’ll tell you anyway. When I was a kid my dad used to take me with him to the dump to unload unwanted junk from our station wagon. On returning from the dump, we’d have more stuff in the car than we started with! In a nutshell, I like productive insight, finding the true value of something that someone has neglected and failed to correctly appraise, and small-cap stocks fit into that perfectly.

As the U.S. enters a new chapter, I believe that investments in small-cap stocks will be better positioned to deal with the economic uncertainty that lies ahead. We know now that bigger doesn’t necessarily mean better. The best investment choice is the one that’s most likely to be nimble and adapt to change, and for this reason I feel that small-cap stocks have a distinct advantage.

Question: What is your outlook for small-cap stocks in 2009 and beyond?

Answer: Small-cap stocks traditionally follow a price pattern into the New Year. In late December, there’s usually some year-end tax selling followed by a nice bounce in January. In addition, small-cap stocks also follow a cyclical rotation whereby investors move out of large-caps and into small-caps. This phenomenon historically provides for very early profits for small-cap stocks out of the chute. I believe that small-caps stocks for 2009 in general will deliver market returns of between 7% and 12% at the very least.

Question: What would you say to an investor who has been scared off by the bear market?

Answer: It’s OK for investors to be scared off by a bear market as long as they are using their time on the sidelines to look for bargain stocks that have been sold off undeservingly. Always have a Watch List, in both good times and bad, so that when your favorite stock goes on sale, you can make a purchase. If you don’t have an immediate need for your funds for retirement or another near-term obligation, you should put that sideline capital to work for you. Investing should closely approximate your risk and comfort level. If the stock market makes you feel uneasy, then putting your money in cash is a good choice. When you do decide to re-enter the market, stock selection will be even more critical than your timing was to get out of the market.

Question: How does the economic climate factor into your stock picks and outlook on the market?

Answer: As always, I’ll be sticking to finding companies that are leaders in their businesses. The only difference given the current market is that I may alter the selection criteria a little. The market has always operated with a here and now mentality when it comes to forecasting earnings. Analysts typically look out three to six months or 12 months and longer to determine a stock’s valuation. In the coming year, I’ll still base my target prices on earnings power, but my range of expectations for the future value of those potential earnings will be shorter. I’ll also be screening investment candidates for any debt, and favor those that have cash and liquid assets. I’ll continue to focus research efforts on industries that are less constrained by discretionary spending.

Investors’ patience has been tested this year and confidence in the stock market is limited. Therefore, there’s no reason for institutions to take on higher risks than are warranted. In light of this new paradigm, investors should revisit the old investment principles, when balance sheet risk and near term profitability were in focus.

Question: How does the bear market affect your investment decisions?

Answer: Naturally, I find myself spending more time scrutinizing any company for inclusion in the Cabot Small-Cap Confidential portfolio, although I’ve always started the investment process by asking myself about the risk of any particular investment before ever considering profit. These days, I’m working beyond the usual starting premise and I’m planning more for the unknowns. A tighter criteria for stock selection is best when transparency matters most.

Question: What else you would like to say to subscribers regarding small-cap stocks?

Answer: Small-cap stocks will continue, in my view, to be the superior investment over time. Every great company that starts out small in business and eventually flourishes to become a large company has origins in venture capital. Somewhere along the line, private investors provided the necessary funding for the company to grow.  Investors will continue to pay for growth, as that’s true the spirit of investing. The markets may re-evaluate what financial metrics matter most for stock selection, but growth will always be in style.