Practical Tips for Small-Cap Investors

Pick the right sectors, boost returns with dividends and diversify using a fund.

Small-cap stocks generally outperform when interest rates are low, which isn't exactly reassuring in a year when the Federal Reserveis expected to raise rates a few times. Fortunately, where small caps are concerned, interest rates aren't the only thing to consider.

The small-cap market is generally defined as the smallest 10 percent of stocks, says Eric D. Nelson, a certified financial analyst and managing principal of Servo Wealth Management in Oklahoma City. Although rising rates can be a drag, small-cap stocks will be one of the biggest beneficiaries of the tax code changes this year and have had some of the biggest positive earnings since December, says Sean Lynch, managing director of equity strategies for Wells Fargo Private Bank in Omaha, Nebraska.

This asset class also supplies essential growth to any portfolio. From 1926 through 2016, small-cap stocks returned an average of 12 percent annually, versus 10 percent for large-cap stocks, says Robert R. Johnson, co-author of "Invest with the Fed" and a principal at the Fed Policy Investment Research Group in Charlottesville, Virginia.

Since 1966, in years when rates were falling, small caps averaged returns of 28.4 percent annually while large-cap stocks returned 14.4 percent, Johnson says. But in years when the Fed raised rates – as it is doing now – small-cap stocks trailed large-cap stocks and returned only 5.2 percent annually, versus 5.7 percent for large caps, Johnson says.

Throw in greater volatility (small caps have an annual standard deviation averaging 32 percent, versus 20 percent for large caps, Johnson says), and clearly, investors have to step up their game to invest in smaller companies. These tips will help you spot strong small-cap investments.

Get some help from dividends. In lower-returning markets, the kind expected over the next few years, look for small-cap stocks that pay above average dividends, as they will boost the overall return, says Eric Kuby, chief investment officer of North Star Investment Management. Dividends higher than 2 percent are considered above average for small-cap stocks.

Avoid individual stock picking. Selecting small-cap stocks that will outperform consistently is hard to do, even for professionals, Nelson says. About 96 percent of professional small-cap mutual fund managers underperformed their index over the last 10 years, according to Standard & Poor's scorecard.

Even so, you're still better off investing in small caps through a mutual fund or an exchange-traded fund that exposes you to many companies. "While you may not earn astronomical returns this way, it is a solid strategy for building wealth," Johnson says. "Now, if you were smart enough or lucky enough to identify Berkshire Hathaway (ticker: BRK.A, BRK.B), Amazon.com (AMZN) and Apple (AAPL) early in their existence, you could beat the market. Unfortunately, few of us are that smart."

Look for funds that own companies that are flush. The less debt smaller companies have, the better they're able to withstand volatility or tough times, Kuby says. So try to pick funds with companies in good cash positions. Portfolio summaries on the fund's website and white papers on Morningstar.com and YCharts.com can give you an idea of whether the companies a fund invests in have manageable debt and sufficient cash flow.

Consider active management. During the most recent stock market run-up, many "micro-cap," or tiny, firms were elevated to small-cap status, thereby pushing former small-cap stocks into the mid-cap category. As a result, there is more risk in this asset class now, says James Stefurak, certified financial analyst and founder of Monarch Financial Research. To reduce this risk, investors should consider an actively managed mutual fund.

An active fund manager may know that some very small firms have alternative funding that depends on the quality of their assets and accounts receivable. When credit dries up, these alternative sources are often "the first spigots that turn off," revealing a company with far more fragile cash flow than you thought. "Financial analysts know where to look in individual SEC filings to determine reliance on such financing," Stefurak says.

Check the fund's turnover ratio. The turnover ratio tells you how frequently holdings in the fund are traded. We "target a turnover ratio lower than the median ratio for the small-cap asset class," says Paul Lightfoot, a certified financial planner and president of Optima Asset Management in Dallas. "Higher turnover ratios lead to higher trading costs and are generally less tax efficient." Lightfoot also suggests investing in funds with at least three years of performance history so that you can get an accurate idea of how often investments turn over.

Invest in sectors that will benefit from rising interest rates. The best-performing sectors when rates are rising are energy, utilities, consumer goods and foods. "People need to eat, put gas in their cars, brush their teeth and heat their homes regardless of the direction of interest rates," Johnson says. The worst-performing sectors are autos, durable goods, retail and apparel. Make sure the small-cap funds you're investing in are diversified across different sectors, Lightfoot adds.

Many small-cap funds track an index such as the Russell 2000, but "a large number of companies in the index do not make a profit," Lynch says. A spike or sudden increase in rates could raise funding concerns for these unprofitable companies and dampen the outlook for the entire fund.