Investors often think of small cap stocks as a place to play with a bit of extra "speculative" money. Taking a flyer on that obscure penny stock is not really part of a serious investment plan.
But a professor from the Ivey business school suggests otherwise. Stephen R. Forester, a Ph.D., CFA and a professor of finance at the Ivey Business School at Western University in London, Ontario recently published a study in the Investment Management Consultants Association Journal of Investment Consulting suggesting small-cap stocks should be part of a serious investment portfolio. In an interview with WP he explained small-caps should be a regular part of any portfolio based on a study that finds small-caps outperform large-caps over the long-term.
"We looked at data base of TSX returns from 1950 tow 2009. Over the long-term we found small caps do better. Slicing and dicing the data according to interest rate environment, growth or recession periods, the asset class is more volatile. But on a risk-adjusted basis, using the Sharpe ratio, we found this asset class outperforms over the long term," says Forester.
Focusing on the smallest 10 percent of publicly traded companies--so-called micro-caps--the findings demonstrate that Canadian micro-cap stocks represent a unique asset class. "Even taking into account potential constraints such as limited average trading volume,” including Canadian micro-cap stocks in a diversified portfolio may still be worth pursuing according to the professor.
According to Forester the study is consistent with US studies. "The research goes against some studies in the U.S. that have found large cap stocks outperform....but that are not the case," he says. "We're not suggesting you should have all your money in small caps. But this should be part of your portfolio. There is a better return over time. You can never guarantee future performance, but looking back, if you held small cap stocks then you have would have done well."
The authors are careful to note that there are constraints on trading micro-cap stocks because of the small float and low-liquidity, and they stress that investing in micro-caps should be investigated only as a part of an overall broadly diversified portfolio. There are, however, potential benefits. "We find clear evidence that investors can benefit from diversification that includes a tilt toward Canadian micro-cap stocks," the authors wrote. "We document that Canadian micro-cap stocks have demonstrated superior long-term return performance compared to larger stocks."