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The Case for Investing in Small Caps

July 13, 2020 By Mircea Vasiu

Investors looking at the stock market prices these days cannot stop to notice the multiples. For instance, one of the recent market stars, Tesla, is priced at 6,348 times 2019 earnings, 166 times 2021 earnings, and 20 times book value.  

To many, these multiples are just too much to justify investing. Are there other alternatives to the stock market? One answer is the small-cap value sector. It historically outperformed the large-cap growth sector by a mile, and it currently trades at much lower multiples.

Why Small Caps May Outperform

To start with, small-cap value is an alternative to private equity exposure. Contrarian investors may find it attractive today because it is very much out of favor as everyone piles into growth and tech stocks.

A close look at the historical performance of a $10,000 invested in 1926 in small-cap value stocks when compared to large-cap growth stocks reveals the former outperforming by a mile on a logarithmic scale.

The current market stock market enthusiasm is driven mainly by a new wave of investors, mostly from the retail sector. As industries like sports betting declined dramatically due to the coronavirus restrictions, people turned their attention to Wall Street and the stock market. Fractional investing grew in popularity almost overnight, with thousands and thousands of trading accounts opening each day.

Retail traders are likely the ones driving the prices higher at the moment. But retail traders rarely are investors – they are in for the thrill of making money fast, speculating on the short-term rise and momentum of a stock.

Investors, on the other hand, have a bigger time horizon for their capital. Chasing valuations like the one described at the start of this article is not part of any investment strategy. Instead, the long-term investor looks for value in the ability of a business to generate cash flow today and in the future.

The focus may be today on tech – there is a huge public demand to own any name in the two areas. But if history tells us something, small-cap value’s tendency to outperform throughout time offers a contrarian point of view to the majority of today’s investors.

In other words, long-term investing is more than owning Microsoft, Amazon, Tesla, or Facebook. It is about doing your homework and finding businesses able to generate cash flow and priced at decent levels – the small-cap value sector offers some interesting opportunities.