Small-Cap Investing: The Roulette Wheel of Wall Street


This article is part of ourBetter Investorseries, in which The Motley Fool goes back to basics to help you improve your returns and be more successful with your investing.

Welcome to the roulette wheel of Wall Street: the small-cap investing arena. Small-cap stocks offer the ultimate risk-versus-reward potential to investors, but also come with the added side effects of heartburn and sleeplessness for those who aren't prepared to deal with the consequences of investing in this niche. So let's take a closer look at why investing in small-cap companies may or may not be the right move for you and how to go about picking out what could be the best performer of the coming decade.

The allure
The allure of small caps comes from their mind-boggling ability to consistently outperform large-cap indexes over the long term. Data have shown that since 1927, a small-cap value portfolio would have handily outperformed any type of large-cap portfolio -- whether it was value-, blended-, or growth-oriented. So what gives small caps the ability to outperform considerably larger businesses? These three factors say it all:

  • Small caps are often ignored by Wall Street analysts. These analysts aren't going to waste their time researching a company that they suspect no one follows when they have a huge clientele waiting for their next research report on a much-followed mega-cap stock. Ignorance can be bliss, but in this case, it's to small-cap investors' advantage.

  • Small-cap companies can often grow their business at a much faster rate than large companies. While revenue isn't everything, as we'll discuss in a moment, understand that it's a lot easier for a company like Clearwire (NAS: CLWR) to double its revenue from $600 million to $1.2 billion -- as it's expected to do in 2011 -- than it is for its partner Sprint Nextel (NYS: S) , which would have to double from $32.5 billion to $65 billion to accomplish the same feat.

  • Small caps are their own self-fulfilling prophecy. By offering the largest risk-reward ratio and having consistently outperformed large caps for decades, small-cap stocks have a steady stream of individual investors who are themselves looking to become the next Warren Buffett.

The dangers of small-cap investing
Remember that little point I made above about heartburn and sleeplessness? Well, here's why this could happen to you if you aren't prepared...

The danger of small-cap investing is it's often emotionally based. Even if you're doing your research, there are twice as many out there who aren't. This makes small caps often prone to much wilder price swings than mid- or large-cap companies.

If the volatility doesn't bother you, the lack of visibility might. While not having Wall Street analysts covering a stock is a bonus to small caps' long-term outperformance, it also means having to do considerably more legwork in getting to know the ins and outs of a company. If you aren't ready to break out your pencil and get dirty learning about a company, then you're probably better off staying away from these smaller names.

Finally, there's the most dangerous aspect of all in regards to investing in small caps: being sucked in by a rapid revenue growth story with no earnings. Let's go back to our Clearwire example from above. Yes, the company has doubled its revenue regularly over the past few years. But it has also needed its partner Sprint Nextel to inject it with capital on multiple occasions because Clearwire is losing money hand over fist. This isn't to say that companies currently losing money won't someday be very profitable, but the bottom line is extremely important when investing in small caps.

It's up to you
Now to the meat and potatoes: Who should be investing in small caps?

While "everyone" would be a great response, this just isn't the case. Small-cap investing is definitely geared toward the younger and, to some extent, middle-aged investor who has a considerable amount of time left to retirement and who isn't afraid to take risks. Investors should understand that you should only invest in small caps what you're prepared to lose. Although healthy dividends can sometimes be found among small-cap stocks, I would recommend dividend-income seekers who crave safety to look elsewhere.

Unearthing a gem
If you've made it this far, then perhaps small-cap investing is right for you. Taking into account the risks and rewards we've noted above, if you can find a nice balance of growth, profitability, and sustainability all within the same company, then you're off to a good start.

One of my favorite examples of this is True Religion Apparel (NAS: TRLG) . A relative no-name five years ago, the company has transformed itself from a mere wholesaler, into a branded bricks-and-mortar retailer of premium denim products. The company is growing its sales by double-digit percentages, is profitable, and has a squeaky-clean balance sheet.

Another name that comes to mind is ICU Medical (NAS: ICUI) . The need for health care products is only increasing, which makes ICU's IV products a sustainable, profitable, and steadily growing business platform.

Luckily for you, these two companies are only the tip of the iceberg in the small-cap arena. If you're willing to put in the research, you may just come out ahead of the house in the roulette wheel of investing segments. Good luck, my fellow Fools!

Stay tuned throughout our Better Investor series and get the advice you need to succeed with your investments.Click back to the series introfor links to the entire series.

At the time thisarticle was published Fool contributorSean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.