COLUMN-Finding ugly ducklings in a waddling market

Fri Apr 27, 2012 1:07pm EDT

By John Wasik

CHICAGO, April 27 (Reuters) - Ugly duckling stocks are surprises in small packages that turn into great performing swans later on down the road. Nearly every large company started out as a "small cap," which generally refers to a stock with under $1 billion in market capitalization. Most small companies do unsexy things such as make pumps or generic drugs. You'll rarely hear them touted by big-name analysts or firms.

When business and economic cycles favor them, though, small caps soar relative to big-cap stocks, especially because they are usually priced at a bargain. Over the past three years through April 25, for example, the Vanguard S&P 500 Fund rose 19.4 percent. In contrast, the DFA US Small Cap Value fund climbed 22.7 percent (). Note: The DFA fund, representing an index of small companies, is only available through investment advisers.

Long-term, exhibiting what investment analysts call "the small company effect," these pint-sized stocks produced a compound annual growth rate of almost 12 percent from 1925 through 2011, according to Ibbotson Associates' 2012 Classic Yearbook (). That compares to about 10 percent for the S&P 500 index of large stocks, typically over $2 billion, and about 6 percent for long-term government bonds. Small caps are generally stocks from $300 million to $2 billion in market capitalization; mid-caps from $2 billion to $10 billion; and large caps from $10 billion on up. Much of the small-company/value effect has been documented by academics Kenneth French, Eugene Fama and Rolf Banz ().

Small-cap companies are rarely in the spotlight. Companies like Lifepoint Hospitals, Westlake Chemical and Esterline Technologies, for example, are unlikely to steal the headlines from Exxon-Mobil and AT&T.

Do small caps always outperform large caps? No, there are periods of time when small caps waddle along and fall on their face - witness 2008 - but they eventually pick themselves up again and prove their mettle. Most recently, when euro zone anxieties jolted the market again on April 23, the S&P Small Cap Index fell 1.6 percent in a day, compared to 0.8 percent for the S&P 500.

Overall, small caps tend to be more volatile and pay fewer dividends than their big brothers, so buying individual issues always entails much more risk. Younger companies are also often struggling to become consistently profitable.

The best way to hold small caps is through index funds, which hold hundreds of them at low cost. Consider the Guggenheim S&P SmallCap Pure Value ETF, which attempts to replicate the S&P SmallCap 600 Pure Value Index. Another consideration is the relatively new Bridgeway Omni Small-Cap Value Fund , which follows the Russell 2000 Value Index. Want more exposure to small-cap companies overseas? Look at the iShares MSCI Emerging Markets Small Cap Index, which focuses on small companies in developing countries.

When adding a small-cap fund to your portfolio, it's best to hold it for at least a decade, preferably longer. They should never dominate your portfolio if you can't afford to take much market risk. That means if you're retiring soon or need money for a short-term goal such as a home down payment, don't put your money in a small-cap.

My wife and I, for example, are long-term investors, and we have small-cap value funds in our core individual retirement account portfolio. We won't need the money for at least two decades, so we don't trade these funds, we just let them grow. They are not a part of our daughters' college-savings funds, which we'll begin to tap within a few years.

Small caps may get you where you need to be over time, but they may run in a number of different directions over short periods of time. So be mindful that swiftness and smallness are not the same thing as safety.