Why Small Caps Should Have A Place In Your Portfolio And How To Invest In Them

As large cap growth stocks account for most of the major market gains, it’s no surprise they also dominate investors attention and portfolios. But, people may be overlooking what has historically been a key to diversification and catalyst for steady long term returns; namely the universe occupied by small cap stocks.

small cap company is typically defined by having a market capitalization ranging from approximately $300 million to $2 billion. Below that threshold it is considered a micro-cap and many institutional funds (pension, mutual and even hedge) are prohibited through their chartered mandate from micro-caps. This means individual investors could have an advantage in unearthing small companies before the big guys can come in and pump up their valuations.

However, like many individual investors, I don’t have the time or wherewithal to scour through the nearly 3,000 publicly listed companies considered small caps.

This when Exchange Traded Funds (ETF) can provide both a cost efficient and fully vetted way to gain exposure to the group.

The best known small cap index is the Russell 2000 and the most popular ETF is the iShares Russell 2000 ETF (IWM), which has over $55 billion in AUM.

It is up some 15% for the year-to-date, very respectable, but still lagging its large cap brethren the SPY and QQQ by a whopping 10 and 21 basis points for the YTD. This is the largest discrepancy between the big three ETFs for any 6 month or longer period ever.

As you know, I’m a believer that in investing and finance things (whether it be sentiment, performance or trend) tend to revert to mean and 70 years of history suggests small caps will be due to play catch up in the next 6-18 months.

To take this one step further, right now large cap growth stocks, which are mostly tech related, such Microsoft (MSFT), Apple (AAPL) and Alphabet (GOOGL) are also among the most expensive stocks in the market trading at their highest valuations in nearly 15 years. The average P/E of the top largest 6 stocks is a whopping 32x forward earnings.

On the other hand, the IWM trades at just 12x next year’s expected earnings. And the metrics get even cheaper if you focus on the sub sector of “Value” within small caps which includes many companies trading with mere single digit P/E multiples.

I think small cap value ETFs warrant…

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