Unlocking superior returns with small-cap stocks involves navigating the high-risk, high-reward landscape.

Investing in small-cap stocks can offer the potential for superior returns compared to their larger counterparts. However, this opportunity comes with inherent risks. Shares of smaller companies tend to be more volatile, less liquid, and may experience prolonged periods of underperformance. During times of market turbulence or downturns, small-cap stocks are particularly susceptible to heightened volatility.

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Do small companies have an edge?

Small companies trading on U.S. stock exchanges are typically defined as having market caps between $300 million and, say, $2 billion. That range is generally higher than for many other markets, including Canada. For the most part, index providers define small stocks as those in the bottom 5% to 15% of the market value of the investment universe.

While smaller companies do not have the scale and influence of big-cap stocks, they can sometimes react more quicker to changing market conditions. They may also have less internal bureaucracy to deal with before making decisions. In addition, small firms, when they become successful, can become acquisition targets for larger companies.

Incidentally, it’s a mistake to generalize about small-cap stocks. Some are junk. Others are small companies that have a history of sales and earnings, and attractive growth prospects. Others are industry leaders that have small capitalizations only because they serve a small industry.

Small caps can generate higher returns

Over the past 20 years, global and U.S. small-caps delivered compounded annual returns better than the overall world equities index and the U.S. broad market. Despite being periodically dragged down by a large and often poorly performing mining and energy component, Canadian small caps also performed well, generating returns only slightly below the overall Canadian market.

However, over the past ten years, the large U.S. companies performed very well, leaving medium and smaller companies behind. Smaller companies also underperformed both globally and in Canada over the past decade.

Small-cap con: higher risk

While their returns have been higher over 20 years, the volatility, or risk of the returns, for small-caps is higher than the broad market. Canadian small caps are especially volatile.

During the big market meltdown between 2008 and 2009, U.S. and global small-cap stocks dropped more than U.S. large caps, while Canadian small-caps were more volatile as well.

Relative valuations

Given the relatively weaker performance of small companies over the past decade, it is no surprise that the valuations of the small companies trade at significant discounts to the larger companies.

Keep small cap stocks to a smaller part of your holdings

Small-cap stocks have a role to play in balanced portfolios, but investors should keep their exposure to these stocks at less than, say, 10% of their overall portfolios. Investors should also ensure they take quality, value and volatility into account when selecting stocks or small-cap ETFs.

Note as well that most ETFs focused on Canadian small companies suffer from an extraordinarily large exposure to the Resource sector. That can amplify the impact of any movement in commodity cycles.

What are your investing habits with small-cap stocks? Leave a comment below.