When it comes to stocks, it's easy to equate size with quality. But over the past year, smaller has been better, which means you need to be looking for small-cap stocks to buy.
In fact, the market's practically screaming that you should be putting some chips to work in the small-cap arena.
You see, the Russell 2000, an index of 2,000 small-capitalization stocks, is positively stomping the big boys. In the three months ending in July, the small cap index returned 10.7%, while the broader Russell 3000 returned a paltry 6.6%.
And in the S&P 500 Index, the small fry have beaten the big boys by almost 18% (34.7% to 16.9%) over the last 12 months.
Steven DeSanctis, small-cap strategist at Bank of America Merrill Lynch, says there is still plenty more to come. DeSanctis told The Wall Street Journal he believes the Russell 2000 index will hit 1,100 this year, up 5.7% from recent levels around 1,070.
But this latest surge isn't really new.
Since 1927, a small-cap portfolio has beaten the returns of large-caps by an average of nearly 3%.
Small-cap stocks outperform their bigger brethren for a few simple reasons. After all, they've survived the difficult startup phase, which leaves them with plenty of room to grow.
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But there are strong indications that now is an especially good time to get in on the party. Here's why...
All Stocks Are Thriving Now
There's no doubt about it, stocks have been on a roll. The broad market has more than doubled since 2009. The S&P 500 has soared a whopping 144%.
"Should this bull market continue into its sixth year (March 9, 2014-March 9, 2015), then history says, but does not guarantee, that small caps could see a late-stage surge and outpace large caps once again," wrote Sam Stovall, chief equity strategist at S&P Capital IQ in a recent note to clients. That means it's a good idea to look beyond the big industrial giants for good returns.
And small-cap stocks to buy are not hard to find - three out of four publicly listed stocks are below $500 million in market cap.
What's more, since 2008-2009, many of the investment banking firms that cover the small-cap sector have reduced headcount. That means less research is available on these under-loved companies, keeping them under the radar of many institutional investors.
Most weary analysts aren't about to spend precious hours researching a company that no one follows. So in-the-know investors buying small caps face a lot less competition when trying to pick up shares at a good price.
But when a small outfit begins to show sizzling earnings growth and fundamental improvements, the big guys tend to take notice.
That's when you want to be in a small-cap stock - when that buying pressure hits a relatively small company, the stock can skyrocket.
Yet there's still another reason why now is a good time to be hunting for small cap stocks to buy...
U.S. Exposure Favors Small-Cap Stocks to Buy
In a world where the Middle East could blow at any time and Europe and Asia are still digging out of the economic doldrums, small caps provide a unique safe haven for investors. That's because small caps generally focus on the U.S. economy, making them largely immune to global gyrations.
Simply put, small-cap stocks have less exposure to foreign markets.
Companies in the S&P 500 get about 34% of their revenue from abroad, according to Goldman Sachs analysts, while firms in the Russell 2000 earn only about 20% of their sales overseas, Goldman said. That trend often works to the advantage of smaller, U.S.-focused companies.
Heed the Fundamentals
However, fundamentals are even more critical than usual when looking at small-cap stocks to buy.
Shares of companies that fall short of expectations often get pummeled by selling pressure from disappointed large-scale investors.
While there are always risks, you can maximize your odds by diversifying across a broad spectrum and using a top-notch exchange-traded fund (ETF).
The iShares Core S&P Small-Cap ETF (NYSE: IJR) is a passively managed ETF designed to track the performance of the S&P SmallCap 600 Index. The fund is a popular choice in the small-cap space with about $11 billion in assets. Even though it holds a total of 603 stocks, IJR has only 5.75% of its total assets in its top 10 holdings, with none exceeding 0.68% of assets.
IJR has a nice mix of small-cap stocks. Almost all its investments are concentrated in the United States and have below-average Price/Earnings Ratios (P/Es), a philosophy that promises lower volatility. Its biggest sector investments are in technology and industrials, a solid bet on the U.S. economy.
IJR is also cheap to own, with an expense ratio of only 0.17%. The fund returned a juicy 25% for the 12 months ending August 31, 2013. In fact, IJR has trounced stocks in the S&P 500 over the past 3 years (69% to 53%), 5 years (53% to 33%), and 10 years (143% to 75%).
IJR is clearly one of the better ways to solve the puzzle of which small-cap stocks to buy.
Note: Finding small-cap stocks to buy with massive growth potential isn't always easy. But one sector is particularly target-rich when it comes to small-caps with staggering growth potential...