| Topic - Small Caps: The Road Runners | Education Center |
SMALL-CAPITALIZATION STOCKS have a reputation for being the market's speed demons. That's not entirely accurate, since there are plenty of small, stodgy banks and rust-belt manufacturers in the group. And there are times -- like much of 1997 and 1998 -- when small stocks suffer from the perception that they're too risky in volatile markets. But companies with a market value below $1 billion can by nature grow more quickly than bigger companies. And the good ones can post explosive earnings that drive double-digit returns for investors.
There are several indexes that track small-cap stocks. Probably the most widely referenced is Frank Russell Co.'s Russell 2000, which tracks 2,000 companies with an average capitalization of $592 million. Companies in Standard & Poor's small-cap index, the S&P 600, average about $639 million in market value. Most people, however, consider any company below $1 billion a small cap.
Small-cap companies tend to have correspondingly small revenues. And that means many of them have either just started up or are poised to expand their markets, either geographically or with new products. You'd be hard pressed, for instance, to find a Wet Seal store in many areas of this country, despite the fact that the red-hot teen retailer could find customers anywhere. Giant discounter Wal-Mart, on the other hand, has become a fixture all across America.
The difference in size has a direct impact on how the two stocks behaved over the past few years. Wal-Mart stock grew 145% between August 1993 and August 1998 on the strength of 10% annual earnings growth -- not bad for a large cap. Wet Seal stock, on the other hand, grew 618%, as its earnings soared 64%, averaged annually. The smaller company also experienced much wider price swings. And you can bet it will be much more vulnerable to any inkling of an economic downturn than the mighty Wal-Mart. But Wet Seal's incredible performance would have been a great sweetener to any diversified portfolio.
Risk/Reward
Rapid growth is clearly the appeal of small-cap stocks. But they are not for the fainthearted. Little companies are
significantly more volatile than big companies -- meaning there's much more downside risk. And they don't pay dividends
as often, a real detriment for investors who want some income.
There are other risks as well. When the economy is uncertain -- as it was for most of 1998 -- investors looking for safety and stability will often abandon small caps for blue chips. Also, because small companies have fewer shares outstanding, their price movement is necessarily more erratic. When good news hits the tape, investors clamoring to get in will drive the price up quickly. When bad news hits, the opposite is true, and it can sometimes be difficult to get out. Because fewer Wall Street analysts cover these stocks, there's also less reliable information on them. That means bad news can strike out of the blue, plundering stock prices overnight.
For all of that, however, most investors -- especially young ones who have the time to make up any losses -- want exposure to small caps. As we saw with Wet Seal, the upside potential is simply too great to pass up.