The case for small caps

Sunday's New York Times had a column by Paul J. Lim about the performance of large caps vs. small caps in 2006. Small cap stocks beat the big caps this year, but only because of a huge January, where small caps soared over 7%. The piece addresses the difficulty of handicapping which group will outperform. Financial planner James A. Shambo said that "the market has a tendency to do what most of us think it won't do. It loves to humiliate us."

While it seems clear that picking which category is likely to perform best in any given year is a fool's game, for long-term investors, small-caps have outperformed handily over time. For stock-pickers (which most readers of this blog probably are), it is clear that small-caps are probably the most lucrative source of opportunities. In his book Real Money, CNBC pundit Jim Cramer talks about the strategies of horse race handicapping legend Andrew Beyer, and how they can be applied to financial markets. One of his maxims is: Only go to tracks where there aren't a lot of good players so you can clean up.

The analogy here is obvious. According to the efficient market hypothesis, there are so many people analyzing the stock market all the time that stock prices are always right. Prices are in equilibrium, and the only way to earn superior returns is to take above-average risks. This theory may hold reasonably well for large stocks that are well-followed by Wharton-trained analysts and an army of hedge fund managers. But what about small stocks that are completely off the mainstream radar? Here, people who are willing to devote the time may find undiscovered gems that Wall Street analysts miss because they're too busy endlessly analyzing stocks like GE and Exxon. As Peter Lynch has said, "he who turns over the most rocks wins the game."