Stocks: Small Is Beautiful

Shares of smaller companies are sometimes volatile and risky, but they can provide great opportunities. Here's how to find them

by Ben Steverman

Strategic Hotels & Resorts

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Small-cap stocks can swing wildly from one day to the next. A small company's growth plan can be derailed by a bad CEO, a recession, or one product that bombs. And it's hard, sometimes impossible, to find good objective analysis of small companies.

With these disadvantages, many investors stay away from small-cap stocks. They stick with large- and mid-cap stocks, generally those with market values greater than $1 billion, because bigger companies usually offer investors predictability and more safety. Closely watched by the media and Wall Street analysts, larger stocks are easy for amateur investors to follow.

What's more, the past year has been tough on small caps, as credit worries and a slowing economy put an end to a great seven-year run for smaller stocks. For the 12 months ending Apr. 30, the Standard & Poor's SmallCap 600 index was down 9%, while the large-cap S&P 500 index fell 4.7%. However, the small-cap index outperformed large caps over the past five years (14.7% vs. 10.6% for the S&P 500) and over 10 years (7.4% vs. 3.9%).

C'mon In. The Water's Fine

Some market pros believe this is the perfect time for investors to wade into small caps. While the U.S. economy is barely growing, many large companies are going to struggle to top last year's earnings numbers. That makes fast-growing small-cap companies—often exploiting a booming market or driven by an innovative product—relatively more attractive to Wall Street investors, says Mary Lisanti of the Adams Harkness Small Cap Growth Fund (ASCGX).

More than 4,500 companies with market capitalizations of less than $1 billion trade on major U.S. exchanges, according to data provider Capital IQ. This wide selection can be daunting. And there's often little research done by Wall Street analysts on smaller names, so investors have to rely on their own research to find winners. "There is a lot of reward for work you do digging into these companies," says Bryant Evans, a fund manager at Cozad Asset Management.

Lisanti and other small-cap fund managers say that finding the next big thing in small caps is difficult. "There are no perfect small-cap companies," Lisanti says. "Nobody goes from small to large in a straight line."