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The Contrarian Case for Small Caps

“Are small caps a smart asset class to invest in right now?”

That’s the question I set out to answer for more than 100 investors at our Wall Street Daily conference in Chicago on Tuesday. I figured our broader audience (i.e. – you) would be interested in my analysis, too. Especially since many pundits keep issuing warnings about small caps in the current market.

Earlier this week, for instance, MSN Money ran a column entitled, “Looking for Growth? Small Caps May Not Be the Answer.” And a few weeks before that Reuters ran an article entitled, “Why the Small-Cap Rally May Stall.”

I disagree completely with such a viewpoint. And here are three reasons why…

Contrarian Reason #1: The Past Matters

Over long periods of time, small caps flat out return more than large caps.

Multiple studies on data going back to 1925 confirm it, too. From Ibbotson Associates, Bernstein Research, Fama and French, and more recently, Royce Funds.

The outperformance ranges from 2% to 5% per year. Compounded over time, that’s significant.

As Richard Bernstein concludes, “Small stocks offered the best risk/reward potential to investors.” Period!

Of course, naysayers are bound to quip that we can’t simply focus on really long-term performance. After all, it represents the average annual returns and therefore, masks periods of underperformance.

Fair enough. But that’s still not a reason to write-off small caps…

Contrarian Reason #2: Performance Endurance

Over shorter periods of time, it’s true that small caps don’t always outperform large caps.

However, it’s important to note that small-cap rallies endure… for years.

In every decade since the 1930s, Royce Funds found that small caps enjoyed prolonged periods of prosperity and outperformance. Periods lasting six years long with an average return of 273%.

Against such a backdrop, the current rally for small caps hardly qualifies as long in the tooth. Since the market bottomed three-and-a-half years ago, the Russell 2000 Index is up only 144%.

Again, naysayers are bound to complain we’re looking too far back and we should, instead, focus on most recent history. So, let’s do that then…

Contrarian Reason #3: Don’t Buck the Trend

Since the market hit rock bottom in March 2009, small caps have outperformed large caps by a full 30 percentage points. Most recently, small caps have been leading the way, too.

Since August 1, the Russell 2000 Index is up 8.4%, nearly doubling the return of the S&P 500 Index over the same period.

Put simply, the trend is our friend. And it’s unlikely to reverse course in the near term, either.

I say that simply because earnings expectations keep plummeting into negative territory for S&P 500 companies (i.e. – large caps). The culprit? Exposure to weak European markets. However, small caps lack significant exposure to overseas markets. Accordingly, third-quarter profit forecasts remain firmly positive for small caps.

Thomson Reuters estimates a year-over-year profit decline of 2.1% for S&P 500 companies. But for companies in the Russell 2000 Index, third-quarter earnings are expected to increase 7.9%.

And since stock prices ultimately follow earnings, it’s only natural to expect that small caps will keep outperforming their larger brethren.

Bottom line: At this stage in the bull market, I’ll concede it’s unwise to expect every last small cap to rally. That doesn’t mean we should write-off small caps completely, though. It just means we need to be selective.

Instead of blindly buying into thousands of small caps via an exchange-traded fund like the iShares Russell 2000 ETF (NYSE: IWM), I’d focus on investing in individual small-cap value stocks. With that in mind, I’ll be sure to provide you with some specific opportunities to consider in the coming weeks. So stay tuned.

Ahead of the tape,

Louis Basenese