Finding Good Stocks in a Bad Sector

STREET SMART

- James K. Glassman

Whatever happened to small-cap stocks? The argument for smaller companies used to be simple: Their shares are riskier, on average, than shares of larger companies, but they return more to investors. So, more risk, more reward. That’s a rock-solid principle of investing (and of life, for that matter). Though smallcap stocks may be too volatile for some investors, a small injection of small caps can give a portfolio a nice boost.

One advantage of a stock with a small market capitalization (defined as price times shares outstanding) is that, being small, it may elude the attention of analysts and most investors. Such a stock can be an overlooked bargain. Another plus is that, with a small cap, you have a chance to make gigantic returns on your original investment. If you had bought Netflix in 2008, when it was a small-cap stock trading at about $4 a share, and you had held it until today, you would have increased your initial investment by a factor of more than 100. If you buy Netflix today, as a mega-cap stock trading at $495 per share, that kind of return is unimaginable—its market cap would exceed the current gross domestic product of the U.S.

(By the way, there is no official definition of a small-cap stock. Some experts put the market-cap limit at $2 billion, but the largest firms in popular smallstock benchmarks have market values of $4 billion to $5 billion.)