Small-cap stocks are having a moment but can it last?

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This has, finally, been noticed by investors. Photo by Michael Nagle/Bloomberg via Getty ImagesThis is the first of a few columns on small-cap investing to come over the balance of the year. This sector can be a lonely field. Brokers and advisers generally avoid small caps because they can be risky and volatile. This can create difficult conversations when they don’t work out. In addition, many small companies have no analyst coverage so there is nobody to turn to when you have questions. Finally, small companies generally have much more financial risk. This means, in addition to stock market volatility, small-cap investors need to worry about the companies they invested in actually surviving. Small-cap companies need access to capital before they can prosper and at times this is not always easily available.THIS CONTENT IS RESERVED FOR SUBSCRIBERS ONLYSubscribe now to read the latest news in your city and across Canada.Exclusive articles from Barbara Shecter, Joe O'Connor, Gabriel Friedman, and others.Daily content from Financial Times, the world's leading global business publication.Unlimited online access to read articles from Financial Post, National Post and 15 news sites across Canada with one account.National Post ePaper, an electronic replica of the print edition to view on any device, share and comment on.Daily puzzles, including the New York Times Crossword.SUBSCRIBE TO UNLOCK MORE ARTICLESSubscribe now to read the latest news in your city and across Canada.Exclusive articles from Barbara Shecter, Joe O'Connor, Gabriel Friedman and others.Daily content from Financial Times, the world's leading global business publication.Unlimited online access to read articles from Financial Post, National Post and 15 news sites across Canada with one account.National Post ePaper, an electronic replica of the print edition to view on any device, share and comment on.Daily puzzles, including the New York Times Crossword.REGISTER / SIGN IN TO UNLOCK MORE ARTICLESCreate an account or sign in to continue with your reading experience.Access articles from across Canada with one account.Share your thoughts and join the conversation in the comments.Enjoy additional articles per month.Get email updates from your favourite authors.THIS ARTICLE IS FREE TO READ REGISTER TO UNLOCK.Create an account or sign in to continue with your reading experience.Access articles from across Canada with one accountShare your thoughts and join the conversation in the commentsEnjoy additional articles per monthGet email updates from your favourite authorsSign In or Create an AccountBut before we delve into the sector, let’s first examine small-cap investment performance. We will look at the small-cap stock index in the United States, the Russell 2000 (RTY). We will also examine two small-cap exchange-traded funds: the iShares Russell 2000 Growth ETF (IWO) and the iShares Russell 2000 Value ETF (IWN).Canada's best source for investing news, analysis and insight.By signing up you consent to receive the above newsletter from Postmedia Network Inc.A welcome email is on its way. If you don't see it, please check your junk folder.The next issue of Investor will soon be in your inbox.We encountered an issue signing you up. Please try againBest investment performance periodSince small-caps can be lonely, volatile and, yes, frustrating, why do investors buy them at all? It is the allure of higher performance. Small companies can grow faster than large companies. Small companies can attract more attention as takeover targets. Small companies can be nimbler in their business dealings. But has this really resulted in better performance? Well, not over the past 25 years. We will discuss this below. But first, let’s look at how things went when small caps were working in the market. The RTY started weak in 1984 but then surged 28 per cent the following year. It went up 45.37 per cent in 2003, up 17 per cent in 2004, up 3.32 per cent in 2005 and up 17 per cent in 2006. Total four-year return: 105.6 per cent. This buoyant period followed the dot-com crash and overall markets did bounce back well following the 2002 recession.Worst investment periodBut alas, the fun times discussed above were followed by the index’s worst period. In 2007 the RTY fell 2.75 per cent, and then in 2008 it fell 34.80 per cent, for a cumulative loss of 36.59 per cent over two years. This, of course, coincided with the Great Financial Crisis so no explanation is needed here. When investors are scared they tend to avoid small-company investments. What is interesting, though, is in a backdated analysis of small caps since 1979 the small-cap index has only had one period when it declined two years in a row, and that was the period just discussed. For the rest of the 47-year period, small-cap investors only had to sit through one down year at a time.CompositionThe composition of the small-cap index varies widely from large-cap indices. While the RTY only has about 14 per cent exposure to technology companies, the S&P 500 is dominated by them. Health care is 20 per cent of the RTY, versus only about nine per cent for the S&P 500. Financials are 18 per cent, versus 12 per cent for the S&P 500. Industrials are about 14 per cent, versus eight per cent for the S&P 500. The sector differences do result in performance differences between large- and small-company indexes. For example, the large health-care exposure in RTY includes risky drug-development companies. This can be great when clinical trials are a success, but not so great when these trials fail.This advertisement has not loaded yet.This advertisement has not loaded yet, but your article continues below.YieldSmall-cap companies typically do not pay high dividends, as they generally require all of their cash to grow their business. But currently, the yield on RTY is 1.39 per cent as of Thursday morning, versus about 1.07 per cent for the S&P 500. This, of course, is contradictory to the common belief that small caps do not yield much. What’s going on? Well, years of underperformance of small caps has changed their yield. In addition, many small caps have decided to pay more in dividends, as a way to try and attract more investor attention. So, right now, with small-cap stocks an investor can get both a higher yield and higher growth potential. This has, finally, been noticed by investors: The RTY index is up about 18 per cent this year, versus the S&P 500, which is up about 11 per cent.Value versus growthAt the end of 2000, two ETFs launched, which split the small-cap index into two components: value and growth. This gave investors a chance to focus on the area of the small-cap market that most interested them. Both ETFs have gone up but performance results have not been earth-shattering. Considering the risks of small-cap investing, investors have expected more from the sector. Since launch, IWO, the growth-focused ETF, is up about 400 per cent in the 26 years since it launched. IWN, the value-focused ETF, is up 370.17 per cent. Annualized, this is 6.96 per cent and 6.66 per cent, respectively. How does this compare with large caps? Well, if we look at the SPX, the S&P 500 index, it is up about 7.10 per cent annualized in the same period (note, the ETFs have fees so it is not a direct comparison). Still, this largely explains the frustration small-cap investors have had over the past two decades. They have taken on more risk but have not been rewarded for it, at least not until this year.What will it take for small-cap stocks to get moving again? We will take a look at that in a future column.Peter Hodson, CFA, is founder of 5i Research Inc., an independent investment research network helping do-it-yourself investors reach their investment goals. He is also portfolio manager for the i2i Long/Short U.S. Equity Fund. (5i Research staff do not own Canadian stocks. i2i Long/Short Fund may own non-Canadian stocks mentioned.) If you like this story, sign up for the FP Investor Newsletter.We apologize, but this video has failed to load.Notice for the Postmedia NetworkThis website uses cookies to personalize your content (including ads), and allows us to analyze our traffic. Read more about cookies here. By continuing to use our site, you agree to our Terms of Use and Privacy Policy.