Are You Holding Small Stocks? You May Not Get Big Returns

NEW YORK ( TheStreet ) -- Should you load up on small stocks? Plenty of financial advisers think so. But that could be changing.

The advisers believe in the small-cap premium -- the idea that small stocks should outdo large ones over the long term. That approach has produced sizable rewards. During the past five years, the small stocks of the Russell 2000 benchmark returned 26.6% annually, compared to 23.6% for the large caps of the Russell 1000.

However, a growing number of researchers have begun to question the persistence of the small-cap premium. Analysts note there have been long periods when large stocks outperformed. "I am highly suspicious of the small-cap effect,'" says Tim Loughran, professor of finance at the University of Notre Dame. "Large stocks outperform 50% of the time."

The small-cap effect first gained wide notice in 1981 when Rolf Banz of the University of Chicago published a paper on market returns. Banz argued small stocks had outdone large ones by more than three percentage points annually during the previous five decades.

Many academics endorsed the findings, encouraging mutual fund companies to introduce hundreds of small-cap funds. But almost as soon as Banz announced his discovery, small stocks appeared to lose much of their edge.

From 1978 through 2013, the Russell 2000 returned 12.1% annually, compared to 12% for the Russell 1000. "There is not a lot of evidence that the small-cap effect has had pervasive influence in the last couple decades," says Alex Bryan, a Morningstar analyst.

Some researchers argue that in the decades before the 1980s, small-caps shined because of strong performance from the tiniest stocks, including stocks that traded for less than $1 a share. Because such stocks were hard to trade, they often suffered depressed prices. Investors who bought the bargain-priced stocks tended to obtain outsized returns.

But over the years, transaction costs declined, and it became easier to trade illiquid stocks. As a result, microcaps strengthened and no longer produced such big premiums.

David Koenig, an investment strategist for Russell Investments, argues there is a small-cap premium for investors who can hold on for many decades. The problem is there have been many 10-year periods when small stocks trailed. So investors who scoop up small-caps at the wrong time could be disappointed. Still, Koenig argues that portfolios should include some small stocks. "The main reason to hold small stocks is for diversification," he says.

Alex Bryan of Morningstar says small-cap growth stocks have been particularly disappointing. These include technology and other glamor stocks. After being bid up to excessively high levels, the hot stocks often delivered poor returns. The small blend and small value categories have proved more reliable, often outdoing large counterparts. "If you are looking to enhance returns, probably the best approach is to tilt toward small value," says Bryan.

To emphasize small value stocks, consider Royce Opportunity (RYPNX), a mutual fund. Portfolio manager Buzz Zaino likes to find underperforming companies that are poised to revive. He often buys after new managements take over businesses and begin restructuring. Many holdings are microcaps. During the past five years, the fund returned 29.6% annually, outdoing 95% of peers.

A holding is Identive Group (INVE), which provides Internet security, enabling businesses to prevent thieves from gaining access to systems. Zaino says that the shares fell after the company made acquisitions and the balance sheet deteriorated. New management has begun refocusing the business. "They are selling off some lines and paying down debt," says Zaino.

Another solid mutual fund is American Beacon Small Cap Value (AVFIX). During the past five years, American Beacon returned 24.9%, outdoing 74% of small value funds. The fund employs several small value subadvisers, outside managers that each oversee a sleeve of the portfolio. Since each manager follows a somewhat different strategy, the portfolio holds a diversified selection of stocks.

One of the subadvisers is Mark Roach of Dreman Value Management. Roach prefers companies that are in the cheapest 20% of their industries as measured by price-earnings ratios and other measures. "We like to find stocks that have been beaten up, and then we hope to hold them for two or three years," he says.

A holding is FirstMerit (FMER), an Ohio bank that has been growing by purchasing institutions that were damaged by the financial crisis. "They have made some strategic acquisitions that will do well as lending activity begins to increase," he says.

At the time of publication the author had no position in any of the stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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