Small Caps Still Have Some Spunk Left

For years, editors of Lombardi Financial have steered their subscribers away from large-caps and suggested focusing more on small-caps. Considering that small-caps have delivered impressive returns in the past five years of 15% in Canada and 13.5% in the U.S., I’d say many of you have listened. And, while your traditional stock or bond funds may barely cover inflationary effects in your retirement portfolio, small-caps may still have some spunk left in them–provided you’re thinking long term.

The case for small-caps is best made based on their historical performances. In the long-term, small-caps have historically outperformed large-caps. Partly, the reason was that buying large- caps or bonds has become so expensive that even those meager returns would be literally sucked into fees and commissions for years to come.

Let’s look at the S&P 500 Index, where we encounter bits of “tell- all” historical data. For the past decade, the index yielded a real return (adjusted for inflation) of about seven percent. Notably, some years were better than others. However, if the real return was higher than seven percent one year, in subsequent years it was typically lower, thus returning again to that psychological barrier of seven percent when averaged over a time period.

For example, during the tech bubble, the S&P 500 index was yielding well over seven percent. However, after the bubble burst, that return dropped to between three and five percent over the next few years. Not to mention, after average management fees of about two percent were put into equation, well, you get the picture… not much was left to go on.

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In case of bonds, the real return situation is even worse. Bond yields currently hover, rather hopelessly at this point, at about four percent a year. So, if you are a realist enough to adjust your returns for two to three percent of annual inflation, you’re practically left with nothing.

On the other hand, small-caps offer a much better real return scenario. For starters, small-caps still have plenty of room to grow, while large-caps are stuck in their mammoth sizes. Small-caps are also quicker to jump on an opportunity. Historically, this “agility” factor has provided small-caps with huge payoffs.

Of course, just saying to look for investment opportunities in small-caps is like looking for a needle in a haystack, an apropos cliché. Our mantra has always been to buy relatively cheap small caps that are considered undervalued in their category. Also, we always urged you to diversify by having only a portion of your portfolio in this asset class.