In this month’s edition of “Money Matters,” Scott Oeth talks about the advantages and disadvantages of including small company stocks in your financial portfolio.

Money Matters: Including Small Company Stocks in Your Portfolio Transcript

0:00:00.2 CJ: WTIP is pleased to bring you another edition of Money Matters, a monthly feature intended to help us understand more about managing our finances. Scott Oeth is a certified family planner and adjunct professor. He works with many individuals and has taught retirement planning and wealth management strategies to hundreds of financial professionals. And Scott's joining us now by phone. Good morning, Scott.

0:00:22.5 Scott Oeth: Good morning, CJ.

0:00:23.9 CJ: So, today we're going to talk about small company stocks. Why is that important?

0:00:29.6 SO: Yeah, I love this topic and to keep the legal department happy, I have a disclosure. We're talking about an investment topic, and I always recommend listeners do their own research as to how these types of things may fit their situation or not, seek their own expert opinion. We're just having sort of an educational discussion here. But we're talking about small company stocks in this context when referring to publicly traded companies on the stock market, ones that are really between 300 million and two billion in market capitalization—the value of all their shares in the stock market. So, yes, it's very small compared to the big behemoths in the market, but we're not talking about the little shop on the corner. These are still large companies with hundreds or thousands of employees. The reason I want to talk about it is these smaller companies can be overlooked compared to the big attention-grabbing large companies, especially those in technology, which have been really star performers over the last few years. These smaller companies haven't really performed as well in the last few years, but they have turned in very impressive long-term average returns, which is part of the reason why someone might want to consider buying some in their 401k, IRA, or investment account.

0:01:40.9 SO: I had a good friend when I was young and he had this t-shirt that said, "Small, but mighty" on it. The story of the stocks, and to maybe make the point, CJ, in 1981, there's an investment researcher, Rolf Banz, and he wrote a piece in the “Journal of Financial Economics” where he looked at the very long period of 1926, all the way up to 1980 and found that the outperformance of small company stocks was about 4% per year on average. So, a large gap there. And then a bit later there's some professors very well known in the investment field, Eugene Fama and Ken French, they're both Nobel laureates for this work. They developed what they call the Three-Factor Model, and they identify in that what they call the size effect and show that smaller company stocks tend to earn higher returns over the long haul than large companies. In fact, they showed that these factors that they identify could explain about 90% of the returns in a portfolio. So, some attractive and appealing return numbers over very long periods of time.

0:02:49.3 SO: Another thing that I always like to talk about, CJ, I think is important to consider is diversification, spreading your risk in your investments and putting out a very wide exposure to capture returns because they often emerge where we're not necessarily expecting them. So, being spread out to be able to capture those over time is important.

0:03:10.1 CJ: So, when you're talking about smaller companies, are these relatively new companies starting out, they just haven't gotten to the mega size yet or are these companies that stay in that classification of a smaller company over a longer period of time?

0:03:26.1 SO: Both really, CJ. So, some of them are new and emerging and they just haven't grown, and they will over time. Other ones are companies, I can't really mention names, but ones that you or I would be familiar with that we've known for, you know, most of our life, and we look at them and say, oh, that's a big operation, you know, my brother-in-law works there or something like that. They're just not big compared to the large, what you consider blue chip companies, or lately we've been talking about the magnificent seven, these hero big technology type companies.

0:04:00.2 CJ: What sort of market conditions favor these smaller companies and what are the potential benefits of going with them?

0:04:06.8 SO: Caution against what we consider market timing, making broad moves in and out of the market, trying to time these conditions. But many investors do like the idea and want to apply what we may consider a tactical, maybe lean, tilting towards areas where there's apparent opportunity in the market and pulling back from areas where there appears to be risk. And there's a few conditions now that I think might warrant that small company stock lean. And a big one is what you consider valuations. What are you paying for these companies in comparison to their earnings and the value of their company and their book value and their profits? Many financial analysts out there right now think the current valuations of small companies are quite attractive, both compared to other areas of the market and compared to themselves over periods of time. So, you know, I don't know about you CJ, I'm a bargain shopper. I like to find bargains in many areas of my life. And same thing with investing and basic investing concept is you want to buy low. And I say many professionals think that small companies are offering that right now.

0:05:15.1 SO: There's maybe a couple other current conditions that could support small company stocks. You know, there's wow, there's a lot of headlines about tariffs, trade wars right now, unchartered territory here in terms of how quickly they're being applied and what this might do to the overall market. But there is the case that a lot of these smaller companies do most of their business primarily within our country's border if you're doing domestic small company stocks. And they might not be as susceptible to these trade war impacts as the big international companies. And the other thing is interest rates. So, we had some interest rate cuts last year. More of these smaller companies borrow money and so this could be seen as a tailwind. Now, these interest rate cuts seem to be on pause for now as we're still figuring out if we conquered inflation or not, but if interest rates are cut further, there's the thought that this could provide a nice lift for these smaller company stocks.

0:06:08.8 CJ: That sounds pretty appealing, but what are the risks to consider when going with smaller companies?

0:06:14.5 SO: Yes, the other side of the coin, we think about the potential upside. That's fun to think about. Really need to consider the risk and is it an appropriate investment for yourself? So, one of the biggest, the smaller companies, CJ is these are typically weaker companies. They aren't as dominant. They don't have the big footprint in the market that larger companies do, and when you look at broad small company indexes like the Russell 2000 is a common measure, you'll see in the investment press that covers small company stocks. About a third of these small companies aren't even profitable. They're not dropping a profit to the bottom line after they pay their employees and pay for their development and things like that. Quite a few of these companies are likely to fail or even if they don't fail outright and go out of business, just underperform the broader market. So, I really think, as in many areas, we want a wide exposure here. I'd be very cautious about placing bets on specific companies unless you really can afford to, and it's maybe just a small slice of your portfolio. We want to spread the risk. The other big piece is with this high long-term return that small companies have offered, they tend to be very volatile.

0:07:26.5 SO: So, they bounce around a lot more than big, more established companies. You have to stomach that ride of the ups and downs, and the returns have not been as consistent. There's been long periods where you look at it and say, "What's happening? Why do I own these things? I thought these are supposed to deliver great long-term returns". Really interesting piece. There's a professor at Wharton, Jeremy Siegel, very well known in the investment industry. And his flagship book is called Stocks for the Long Run. Really one of my top recommendations. It's a fascinating book, very readable, and he's great at taking in depth investment, academic research and turning into layperson type terms. But he points out that small company stocks have explosive growth, averaging over 35% return from 1975-1983. So that's a good run, but it's very short when we're talking about this many decades, 75 year long, 100-year long timeframe. But he points out that this short period of time from 1975-1983 really accounts for a large part of what appears to be the small company stock outperformance over say that 75- or 100-year period.

0:08:36.4 SO: He's coming to the point, saying don't be fooled by the numbers. It may just be that there's a huge burst in returns in smaller companies. So, I think with that, one other point, there is a big difference between what analysts would consider growth companies and value companies. Value companies is that bargain hunting, where the price that they're trading at really looks like it's justified by the fundamentals of the company. If you peel back the layers there, the value companies, small company value companies are the ones that really delivered the outsized performance. And small growth companies typically have brought a lot of volatility, not necessarily the outperformance over the long haul. So, as always, take a diversified approach, spread your risk, get an expert opinion. Does this apply to you, and should you add some of this to your portfolio?