Small Is Beautiful (GM, DAL, VBK, SPY, MDY)

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Read any basic investment book and it will tell you that small-cap stocks are riskier than large-cap stocks. On an individual basis, that may be true. However, if you do your homework and dig deep into the financials of small-cap stocks, you can reduce risk and increase reward dramatically.

For the record, small cap analyst Tyler Laundon points out that small caps tend to outperform large caps over the long-term. He believes that many investors mistake small cap 'risk' for what is actually short-term price volatility. He suggests that over the long-term this volatility gets smoothed out, and can actually be used to the benefit of opportunistic investors.

I should also point out that large-cap stocks are not immune to poor price performance, going out of business or declaring bankruptcy (see General Motors (NYSE:GM), Lehman and Delta Airlines (NYSE:DAL) for examples).

On the other hand, many of today's large-cap stocks started as small-cap stocks and grew to the behemoths they are today. When you catch the right small-cap stock at the right time, you have caught a shooting star.

Imagine buying Microsoft in the late 80s or early 90s for less than a dollar a share, or buying Apple in 1985 for less than two dollars per share! Both of these companies are American success stories, started as small-cap stocks and have literally made fortunes for early buy and hold investors.

Some analysts are incredibly gifted at finding these 'needles in the haystack' and perform all of the right analysis. But many individual investors don't have the time, and so miss out on the tremendous opportunity in small cap stocks.

These investors can just buy the whole haystack. What do I mean by that?

If you are looking for exposure to small-cap stocks but don't have the time to comb through all sorts of statistics and financial reports, you can buy a small-cap Exchange Traded Fund (ETF).

With an ETF you get instant diversification among a number of small-cap stocks. This diversification shelters you from single stock risk, but can allow you to boost your overall portfolio performance.

Getting back to the first paragraph of this article, modern investment theory suggests that small-cap stocks are riskier than large-cap. Looking at a chart of the last five years and comparing the performance of three different ETFs, modern investment theory did not hold up.

In this chart, one of my favorite small-cap ETFs, The Vanguard Small Cap Growth ETF (NYSE:VBK), is compared to the large-cap SPDR S&P 500 (NYSE:SPY) and the SPDR S&P MidCap 400 (NYSE:MDY).

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What you should note about this chart is that the VBK climbs higher over the sample period, essentially drops the same amount during the bear market years and then significantly outperforms during the bull market rally from the March 2009 low.

To help make the returns a little clearer, I put together the following table.

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What we see is that the VBK and the MDY dropped a fraction less than the SPY did during the first 31 months of the sample period. Then after the market bottomed in March 2009, the VBK outperformed the MDY and SPY by 21 percent and 57 percent, respectively. By not dropping as much and then experiencing a bigger rally, the VBK's five-year return was drastically better than both the SPY and MDY.

There are two points that I am trying to make here.

First, small-cap stocks can be just as safe as large-cap stocks if you do your homework. The small-cap sector can also provide returns that are almost impossible to get from large-cap stocks.

My second point is that there is safety in numbers. A small-cap ETF can help you diversify your portfolio and at the same time enhance your overall portfolio performance. If you don't want to do too much homework but still buy great individual stocks, you can seek professional help from experts like Tyler (learn more about Small Cap Investor PRO here), or buy an ETF like the VBK; or both.

Either way, sometimes small is beautiful.

Article contributed by Rick Pendergraft, Editor of Wyatt Investment Research's ETF Master Portfolio.

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