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Smashing Myths About Small- and Micro-Cap Stocks

By Peter T. Sidoti, founder, chairman, CEO of Sidoti & CO.

NEW YORK ( TheStreet) -- Big returns often come in small packages. Since the current bull market started in March 2009, the Russell 2000 index is up approximately 200% compared to a 150% gain in the S&P 500.

In addition, statistics from Vanguard show that between 1927 and 2012, small-cap stocks produced average annual returns of 12.9% vs. a 9.9% gain for their larger counterparts.

With consistent outperformance, why aren't more investors paying attention? Small and micro-cap stocks have often gotten an unfair reputation as being too risky or too volatile for many investors. The truth is, however, we believe those who write off these asset classes are missing out on solid earnings potential from some of the healthiest companies in America.

It's important to correct some of the common misconceptions surrounding this group of stocks. One myth is that there is a diminishing amount of interest and information on small caps. About 14 years ago, perhaps there were two firms covering smalls and micros. Today that number is more like six, including Sidoti, founded in 1999. Numerous smaller research firms have opened their doors since 2001 and access to information is greater now than ever.

Here are more myths:

Myth: Operating risk is greater for companies with sub-$2 billion market capitalizations.

KISS. Keep it simple, stupid. Look at the operating risks facing the big guys such as General Electric (GE), Citibank (C) and ExxonMobil (XOM), which have a diverse mix of businesses in just about every country in the world. Every day, they must navigate tricky government regulations, thorny cultural differences and volatile currency swings. These create potential risks that don't exist in smaller companies with much fewer business lines.

Myth: Companies with market capitalizations below $2 billion incur greater financial risk.

Our experience says otherwise. Sidoti researches nearly 700 small- and micro-cap names. Since the economic downturn of 2008, no company Sidoti follows has filed for bankruptcy or required a government bailout. Yet, Thornberg Mortgage, Chrysler, MF Global, Conseco, CIT, General Motors and Washington Mutual all had more than $30 billion of assets when they filed for court protection. We have no ready explanation for this, but we believe the harsh conditions under which banks and other providers of financial services have operated over the past 10 years make the companies in our universe much stronger.

Financial service providers are more selective on companies with which they work and to whom the provide financing. Also, many smaller companies are less confident in their ability to access available financings -- like credit lines -- during times of difficulties, given their experiences in 2008-09.

Many of the companies Sidoti covers have relied on free cash flow/internal cash flow to finance their operations.
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