Why you should buy small-cap stocks if you want to beat the market

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Over the long-term, small-cap stocks have performed extremely well

One piece of wisdom you’ll hear often is that small-cap stocks beat the rest of the market.

Of course, it doesn’t happen every year. 2014 wasn’t awful, but it wasn’t a belter for small caps either. And you always have to take ‘received wisdom’ – particularly in the City – with a pinch of salt. Anyone who says they’ve found a surefire way to beat the market is usually talking out of their hat. If it was really that easy, everyone would do it! Prices would then rocket, and we’d have to look for opportunities elsewhere.

However, this is one of those odd exceptions to that rule. The reality is that research shows that some investment styles do genuinely seem to work better than others over time. And one of those is investing in small caps.

The key point to remember is that while returns in any given year might fluctuate, over the long-term small caps have done really well.

Let’s take a closer look at the Numis Smaller Companies Index (NSCI). That specific index focuses on the bottom 10% of the stock market by value. The biggest stock in the same is worth £1.2bn – in many ways, more of a mid-cap share.

Each year, Professors Elroy Dimson and Paul Marsh – two very highly-respected London Business School academics and market researchers – provide an update on small-cap returns. It’s always a fascinating read, particularly for anyone interested in small companies.

Last year, in 2014, mid-cap shares outperformed both their smaller and larger peers – but only by a pretty small margin. The NSCI returned 0.8%, which fell just slightly behind the FTSE All Share Index’s 1.2%. Meanwhile, the FTSE 100 came out worse than small-cap stocks with a return of 0.7%.

Those numbers are so close as to be irrelevant. But when you pull back and start looking at Dimson and Marsh’s data over time, the picture changes drastically.

How to make your millions with just £100

Imagine you could sit in a time machine, travel back to 1955, and invest £100 in three different indexes: the FTSE All-Share Index, the NSCI (that’s the smallest 10% of the market, remember) and the Numis 1,000 – which is even smaller, following the bottom 2% of the market by value. The Numis 1,000 has more than 500 stocks, of which the largest company is worth just under £500m.

By now, the funds invested in the FTSE All Share Index would have transformed from £100 into £82,000. That’s a pretty decent return, even given that it’s a 60-year period.

But your £100 invested into the NSCI would have become a far chunkier £494,6000. Now you’re talking, that’s proper money.

Yet both of these investments would have been completely over-shadowed by the Numis 1000. From £100 in 1955, it would now have ballooned to a whopping £1,116,100! You’d be a millionaire.

That’s a sizeable return by any reading. Those extra returns generated by the very smallest companies have turned into massive extra gains over that period – as Einstein purportedly put it: “Compound interest is the eighth wonder of the world”.

And these are legitimate numbers. This isn’t the equivalent of cherry-picking Asos as a ‘typical’ Aim share. These are simple broad indices.

But of course, not every year was a winner during this period. And when you look a little closer, there are a few points to note.

Expect more returns from small-cap stocks

You may have made a killing over the past 60 years. But it was the first 30 that generated the meatiest returns. Once we hit the mid-80s, and investors began to catch onto the success of the small-cap market, it fell into a decade of underperformance.

However, over the past 15 years the tables have turned. And Dimson and Marsh reckon that the small-cap ‘premium’ will persist in the future. We might not see the same sorts of returns we saw in the past 60 years, but there’s still money to be made.

For more on this topic, you might want to watch Merryn Somerset Webb’s interview with small-cap veteran Gervais Williams – he reckons that small-cap stocks, and Aim stocks in particular, are definitely the place to go for anyone looking for investment returns in a post-credit crisis world.