Small-cap stocks have outperformed large-cap stocks over time, especially over longer time frames. For example, small caps outperform large caps over half the time during rolling three-year periods—a figure that jumps significantly for rolling 20-year time frames.
Further, small-cap stock prices are disproportionately affected by external factors, making independent fundamental research crucial to identifying the most mispriced securities. Thus, a long-term outlook informed by primary research is critical.
The role of primary research has become even more vital since cutbacks in published research coverage have fueled greater information inefficiencies. The average stock in the Russell 2000 is now covered by roughly six analysts, versus nearly 20 for large caps.1
As long as non-fundamental factors partially drive them, small-cap stock prices will swing at times to irrational extremes. By remaining grounded in the fundamentals, a skilled active manager with a long-term outlook can both recognize and capitalize on these disconnects as they arise.
To be successful, active small-cap managers must rely on a constant flow of dialogue with management, deep understanding of business fundamentals, and an awareness of industry cyclicality.
1“A historical look at small caps.” March 22, 2011. Bank of America, Merrill Lynch.