Small-caps: Rooting for the Underdog

“Calling the Trend” Column, by George Leong, B. Comm.

In 2009, the small-cap Russell 2000 gained 25.22%, which was ahead of the larger-cap DOW and S&P 500. So far, nearly three months into 2010, small-cap stocks are leading the broader market, with the Russell 2000 up 3.52% versus 0.48% and 0.26% for the NASDAQ and S&P 500, respectively. Blue-chip stocks are down, with the DOW off just under one percent.

The buying in small companies is not a surprise given that this group generally rises with the economy. If the trend of economic renewal continues, we expect small-caps to continue to outperform in 2010.

Yet, you will not see Wall Street cheerleading for small-caps. The reality is that Wall Street typically focuses on larger companies. The rest “fly” under the radar, being largely under-followed and, thus, by extension, largely undervalued.

Why? Simply put, for big Wall Street firms, there is no money in following small- and micro-cap companies. As a result, regardless of how good a story behind a company is — and regardless of how strong its fundamentals are — Wall Street continues to ignore this rather large pool of good investments.

The Street has grown over the years. Big banks have bought out small independent brokerages and small independent brokerages have kept on merging amongst each other to grow into bigger ones. This has left small-caps out in the cold, with no one interested in promoting stories that brought little in fees. These days, brokerages make money only if they promote the most liquid stocks, which are in turn only large-caps. You could call it the catch-22 of 21st century investment banking.

There is one more reason why the Street does not like to research small-caps. That reason is trading margins or, rather, a lack thereof. Namely, as competition among brokerages became more and more cutthroat, trading margins became narrower and narrower. Today, no trading desk has “play money” to spare for speculating on development-stage companies. Plus, only large-caps are liquid enough to keep those trading margins safe.

Luckily, that is also where independent research companies come handily into play. They do not get paid through investment banking fees. They also do not trade the stocks they recommend. Rather, they are driven by the success of their picks. Their only allegiance is to the readers of their reports.

If Wall Street is not interested in small-caps, then why should individual investors be? As with everything else, there are pros and cons when it comes to investing in small-caps. However, one of the biggest “pros” is value. There are so many great little companies that no one has ever heard of before. There are companies with breakthrough science behind them and companies operating in a niche market. Yet, because Wall Street is focusing on larger companies, their stories go undiscovered and their stock prices go undervalued for years on end.

As I said, as the economy picks up, small companies tend to do better than larger companies due to their flexibility to react. I remain long-term positive, as small-cap stocks have proven to be tops over the long run. The key is to maintain diversity within your portfolio.