Small cap stocks are on fire.
According to The Wall Street Journal, small cap stocks are trouncing large caps by the widest margin in more than two decades.
The Russell 2000 index of small companies has climbed 15%. That is far above the S&P 500’s 4% rise.
It gets better…
Over the past six months, small caps have trounced the S&P 500 by just under 30 percentage points.
The Russell 2000 is trouncing the Nasdaq by the largest margin on record, going back more than three decades.
If this outperformance continues, 2021 could be the year of the small cap stock.
The Small Cap Effect
You may have heard of the small cap effect.
It is the observation that small cap stocks outperform large cap stocks over the long run.
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Nobel Prize-winning economist Eugene Fama and his colleague Kenneth French famously put this theory to the test.
Their conclusion?
Small cap stocks did indeed generate higher returns over time than large cap stocks…
Though they did so at the cost of higher volatility.
Between 1925 and the end of 2006, U.S. small caps rose 15,922-fold.
That compares with a return of 19 times principal for “safe” U.S. government bills over the same period.
(Had you invested in small cap stocks at the bottom of the market in June 1932, you’d have generated a 159,000-fold return.)
So why do small caps outperform large caps over the long run?
Some argue that it’s because investors have less information about small caps. So the market is inefficient.
After all, Wall Street brokerages make little money tracking and trading small stocks.
Others say small companies are just nimbler.
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Small caps move like speedboats, while large companies are like oil tankers.
It’s worth remembering that today’s leading large cap stocks were once small cap stocks.
Apple‘s (Nasdaq: AAPL) market cap was just over $1 billion when it went public in 1980. Microsoft‘s (Nasdaq: MSFT) value was a lowly $780 million.
Today, both are trillion-dollar-plus companies.
Timing the Small Cap Effect
Strong performance doesn’t make investing in small caps easy.
After all, small caps can underperform for decades, making them a difficult asset class to hold.
However, I also believe in taking what the market gives you.
You have to recognize when some strategies work – and when they don’t.
Today, I see three major factors driving demand for higher-risk, higher-reward small caps.
First, megacap technology stocks have been the market leaders for the past few years. These widely owned stocks will eventually run out of steam. In contrast, small cap stocks have been both under-owned and undervalued for the past decade.
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Second, the ranks of small cap stocks include many cyclical industries, like energy, materials and banking. Earnings in these industries were hit much harder than others during the pandemic. With the U.S. economy recovering, these stocks may lead the market in the rebound.
Third, small cap stocks may have surged in recent weeks on rising investor speculation. And it’s not just about GameStop. Investors are betting that a stimulus-friendly Biden administration, a dovish Federal Reserve and broad coronavirus vaccine deployment will boost small cap stocks in 2021.
How to Profit From the Small Cap Effect
My favorite way to profit from soaring U.S. small cap stocks is through the iShares Russell 2000 Growth ETF (NYSE: IWO).
This ETF tracks a market-cap-weighted index of U.S. small cap growth stocks.
So why do I prefer the Russell 2000 Growth ETF over its rivals?
Small caps tend to outperform during periods of strong economic growth.
And growth strategies tend to outperform value strategies during times like this as well.
Let me leave you with this takeaway…
If you invest only in small cap stocks, you will outperform the S&P 500 over the long term.
The downside of this “one size fits all” strategy is that there are long periods when small caps underperform.
But in bullish years, small cap stocks can shoot the lights out.
The combination of fiscal and monetary stimulus and a robust economic rebound makes 2021 a good time to bet big on small cap growth stocks.
All investment strategies have their seasons.
And today’s investment season is U.S. small cap stocks.
Good investing,
Nicholas
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