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Small Is Beautiful: Now's the Time for Growth-Oriented Investors to Move Into Small-Cap Stocks

Oliver Pursche

I like -- no, love -- large multi-national dividend-paying stocks. If you read my musings, you will notice it's a theme I return to over and over again.

But these large-caps can be sleepy sometimes. For instance, Johnson & Johnson (JNJ), which has been on a tear lately, basically went nowhere from 2005 to 2012. Except for growing its dividend from $1.32 to $2.40 over that time period, the stock was very frustrating to own.

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And sometimes when a stock is going nowhere, the notion of owning smaller, faster-growing companies that are dominating niches and plowing earnings back into the company as the share price rises takes on a certain appeal. I applaud this notion, within reason, especially when it's supported by facts.

I believe such facts are now on hand to support a more aggressive allocation to small-cap stocks. Specifically, while the Russell 2000 Small-Cap Value Index (IWN) has posted similar returns to the S&P 500 (^INX), the valuations are quite different. Whereas revenues for constituents of the S&P have grown by just under 5% over the past 12 months, revenues for the companies within the Russell 2000 Value are up 9.7% year-over-year. More importantly the growth in net margins for small caps are 11.2% versus 9.6% for the S&P 500.

In my view, this comparison, though apples to apples, nonetheless masks an even greater mispricing of small-caps. That is, large-cap P/E ratios may be distorted because earnings are being grown at what I see as unsustainable margin improvements. By focusing instead on Net Assets to Equity Ratio, which is truer than a traditional metric such as Return on Equity, a different picture begins to emerge as the former takes into account pension liabilities.

Small-cap stocks have the reputation of being riskier, young companies whose stock is more volatile than the broader market. This reputation is warranted. Certainly no one talks about JNJ "blowing up." This is one reason why stock-picking among small-caps, rather than broad-sector bets can deliver alpha.

With this in mind, here are some of my favorite names, which are included in my firm's small-cap separate accounts strategy: Cheesecake Factory (CAKE), Lancaster Colony Corp (LANC), Owens & Minor (OMI) and Wolverine World Wide (WWW). Portfolios focusing on low-volatility, high-quality small-cap stocks may be able to reduce overall portfolio volatility and achieve better returns. Growth-oriented investors should start rotating into small-caps, as they could come back into favor soon.

Follow Oliver Pursche on Twitter: @opursche, and see Gary Goldberg Financial Services for more.

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