Why You Should Invest in Companies You’ve Never Heard of Before
May 19, 2015
Investors interested in generating strong profits from their stock portfolios should have a large investment in the stocks of companies they have never heard of before.
The vast majority of investors make a simple mistake: they have way too little exposure to small-cap stocks (and too much to large-cap stocks). Many believe small-cap stocks are too risky and that large-cap stocks are “safer.” The fact is that while small-caps as a group are more volatile than large-caps on a daily basis, all stocks are risky. (The whole U.S. stock market lost half of its value twice since 2000!—before recovering all the losses and pushing to new all-time highs.) The bottom line is that small-caps have delivered long-term performance well ahead of their large-cap brethren (see chart below) and deserve a significant allocation in investor portfolios.
Most people, however, would not recognize more than 5% of the company names if presented with a list of all the publicly traded U.S. small-cap companies.
Investors who have stayed the course have been duly compensated over time for the risks that they take. The chart above demonstrates this fact. The riskier the asset, the better the long term return. The safer the asset, the worse the long-term return. Small-caps, the riskiest of the asset classes in the chart, have done the best while T-bills (the safest) have done by far the worst.
At Orion, our favorite way to access a broadly diversified batch of U.S. small-cap companies trading at bargain prices is through the Dimensional U.S. Small Cap Value Portfolio (Ticker: DFSVX). You can view the fund fact sheet here.
This fund has all the attributes we look for in a small-cap fund:
- It’s full of bargain-priced stocks (aggregate price-to-book ratio of only 1.25)
- Demonstrated stellar long-term performance (click here to see chart relative to the fund’s benchmark, the Russell 2000 Value Index).
- Broad diversification (1,208 holdings as of March 31, 2015)
- True small-cap exposure (median market-cap of $404 million)
- Modest expense ratio (0.53%)
- Very low annual portfolio turnover (only 9%)
- Very tax-efficient
- Fund follows a quantitative strategy and as such is not subject to human biases
Skeptics may say that . . . well, large-cap U.S. stocks beat small-caps handily in 2014. This is true; small does not beat large in every period and should not be expected to. (In 2013, though, small clobbered large, even though both did very well.) Historical data show that sometimes small-caps can lag for years—before they come roaring back.
Stocks in general are a little pricey right now, but we particularly like U.S. small-caps in today’s investment environment. Most small companies are domestically focused and will thus not have big problems with the strong U.S. dollar or exposure to weak foreign economies. (Many large-caps with overseas operations are finding the strong dollar to be a significant headwind.) Lower energy prices will also bolster the purchasing power of U.S. consumers and businesses, which are the main customers of U.S. small companies.
To see how we construct portfolios, please visit our Portfolios page.