If you are investing in small cap stocks, it is important not to make these two big mistakes writes Mark Hulbert for Barrron’s, because after few years of lackluster relative returns small caps look poised to turn the corner.
As Hulbert points, smaller cap stocks have outperformed large caps over the long term but “for the past five years the Russell 1000 (which contains the 1,000 largest U.S. stocks) has beaten the Russell 2000 (the next 2000 by market value) by nearly five percentage points per year”, but in 2016 the trend has started to potentially shift.
In anticipation of improved performance from small caps, Hulbert outlines two mistakes that investors should be aware of and avoiding making when allocating to small cap strategies and/or selecting small cap stocks.
Mistake #1: Beware of Style Drift. Hulbert points out that many funds that call themselves small cap funds may in fact hold larger cap names. Known as “style drift”. According to the article, researchers of style drift have found “that the average small-cap fund with a heavy large-cap exposure returned 6.1% per year less than the typical small-cap fund that invested only in small stocks.”
Mistake #2: Consider Quality Small Caps (Avoid the Junk). When investing in small names, investors should consider financial quality — “profitability, profit growth, volatility, stability of earnings, a high dividend payout ratio and a conservative investment policy” — these are some of the factors that AQR Capital Management found to be important when identifying small caps that have the ability to outperform.
In conclusion, staying true to the small cap arena and focusing on quality are two important characteristics for any investor in the small cap space.