For serious stock market investors who, however, do not wish to or cannot afford to spend a huge amount of time screening and tracking individual stocks, our standing recommendation is to subscribe to one or more of the investment letters we highlight in our E-Book on this subject "High Return Investing with Investment Newsletters".

However, following the individual stock recommendations from these expert advisors requires you to have your money in a taxable or Roth IRA account at a brokerage firm. That does not solve the issue for those of us who also have substantial amounts tied up in retirement vehicles such as 401(k), or 403(b) where the choices available may be limited to mutual funds.

This report makes the case for allocating a substantial part of your long-term portfolio (15 year time horizon) into small cap value oriented mutual funds. Furthermore, if you are an active stock investor (i.e. - you do not simply follow advice from investment letters, but wish to look for your own ideas), then investing in small cap value oriented stocks will offer you the best opportunities for the 10 X potential through bull and bear markets.

Power of Value & Fair Price Investing
Power of Small Cap Investing
Small Cap Value Investing
Trend Shifts
Future
Resources

Over the last 80 years of stock market investing and tracking, value investing has always given better returns than pure growth investing over any reasonable period of time. In fact, most of the major success stories of stock market investing can be classified into two camps:

1. Value Investors - who would pay less than what the current underlying value of a company is (as measured by its balance sheet, cash flow and so forth).
2. "Fair Price for a Great Company" Investors - who would pay a fair price in line with underlying strength of the business, but who would do so because the type of business and the associated management was terrific.

There are very few success stories that are purely Growth Investing success stories - that is, those who would overpay (based on current fundamentals), in anticipation of even greater future successes.

The popular "Efficient Market Hypothesis" that holds that it is impossible to beat the market averages over time because everything that is known about a company is already priced into the market - tends to break down when dealing with either pure value investing or "paying a fair price for a great company" strategy. It does so because these strategies require an exceptional knowledge about the business that the vast majority of investors and traders are unlikely to gain. So inefficiency persists allowing those with the right insight to profit.

Thus great investors such as Warren Buffett, Charlie Munger, John Templeton, Phil Fisher have all made a lot of money with these philosophies.

Power of Small Cap Investing

Smaller companies have more room to grow, period. Large behemoths such as Microsoft and Cisco have to not only maintain their market share, but have to look for the next great thing in order to show even a small improvement in their bottom line. Their stock prices reflect that.

Smaller, innovative companies on the other hand will find their market share and overall value rising quickly even with smaller ideas. Also, companies that are in industries that have suffered a long bear market also get classified as small-cap companies owing to the loss in market share, revenue and profits over the course of the bear market. Many mining companies and other commodity related companies are good examples of this.

The Russell 2000 index, created to track small-cap companies, has returned 9.65% for the last ten years, while S&P 500 has returned 9.28%/year (Data from http://www.russell.com and http://www.barra.com).

Small Cap Value Investing

Given the superiority of value investing and the slight edge that small-cap indexes hold over larger cap indexes, it stands to reason that small-cap value investing would give some significant advantages. It turns out to be true.

From 1926 through 2004, while large cap growth stocks had an average return of about 9.26%, small cap value stocks over the same period returned 15.9%! This 6% difference on an annual basis is astounding. Many of us would thrill at getting a 1% to 2% advantage; a long-term 6% advantage simply cannot be ignored.

This graph from the New York Times shows the rewards of investing $10,000 in small-cap value stocks in 1926 resulting in a billion dollars for you today! (Want to join the billion dollar club?).

To maximize your gains from small cap stock value investing, it is best to invest directly in stocks. However, that can be a very time-consuming affair. The good news is that investing in small cap value indexes such as the Russell 2000 Value would still generate much of the excellent returns associated with small-cap value investing. From 1995 through 2005, the Value Index has returned a value of 13.92% compared to the 9.65% for the Small Cap Index overall (a clear 4% advantage).

Trend Shifts

The stock market tests the best amongst us. Just when a trend seems set, it will switch on you. The moment you think you have the answers; it will test your patience and see if you stick to your guns.

Small Cap Investing has had a great run from early 2002 to present. Making a fresh small-cap investment at this stage may be happening at a local peak for small cap investing. It is possible that large cap investments outperform small cap over the next two-three years.

In general, at the end of each recession, small cap stocks tend to take the lead during economic recoveries, followed by better returns in large cap stocks as the recovery takes a firm hold. As a small-cap value investor, it is helpful to have the wind behind your back; however, it is not necessary. But awareness of the overall cycles helps.

Future

Small cap value investing has held true over a long period of time, and yet it does not attract the attention that the larger indexes do. The best reason for that is that small cap value investing is likely to be more volatile than large-cap investing through S&P 500 or Wilshire 5000. However, here, time is your ally. If you allow your investments upwards of 12-15 years, the value index will generally outperform the large-cap indexes.

A second reason is that value investing, in general, is boring. The stock will not move anywhere for months, sometimes years - before the market accords it a better value. This does not suit active traders, or those investors who wish to feel like they are "doing something".

Part II of the report, to be released shortly, will cover simple implementation strategies for small-cap value investing including portfolio management suggestions.

Resources

1. Russell.com has excellent indexes that track small cap value investing.
2. iShares.com has the actual ETFs that can be purchased to track the Russell indices.
3. Fool.com offers a Hidden Gems newsletter for ferreting out small cap stocks
4. PowerScreener from Reuters can prove useful in identifying stocks quickly

We hope you enjoyed this part of the Report. Please send us feedback at shri_ajay@characterandwealth.com on what you liked or disliked about this report.