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5 Reasons to Add Small Cap Value Funds to Your Portfolio

| February 27, 2017
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What is Small Cap Value?

Investments can be split into four basic quadrants known as styles (Figure 1). These styles correspond to a company’s size (small cap vs. large cap) and a company’s financials (value vs. growth). Which style a company falls in is somewhat subjective and commonly styles are broken into nine sections expanding the grid to show mid cap (between large and small) and blend (between value and growth) funds.

Small cap value companies are generally agreed to be companies with market capitalization somewhere between $300 million and $2 Billion, with low valuations (low price ratios and high dividend yields), and slow growth (low growth rates for earnings, sales, book value, and cash flow).

Why Do You Want These Companies in Your Portfolio?

1) Buying companies on sale

One of the key fundamentals in value investing is to find companies that are on “sale.” However, this is often easier said than done. Value stocks are companies that are selling at a discount, but the difficulty is determining why and if they will recover. There are many reasons a company may shift from growth to value. Often, a company or sector simply becomes out of favor in the market and their stock price falls without any changes in underlying valuations. A successful value fund manager can spot these irregularities and capitalize on the inefficiencies in the market. 

2) Higher dividend yields

Higher dividend yield potential is an inherent qualification of value stocks. As stated earlier, many value companies have simply fallen out of favor with the market without any fundamental changes to the financials. This pushes the price of the stock down while cash flows remain stable enough to continue paying a set dividend. However, higher dividends are not just a value play. In today’s market, many investors are seeking yield, so small companies have increased their dividends in order to attract more investors. This combination can give a small cap value fund a significant boost in dividend yields.

3) More growth potential

Smaller companies simply have more room to grow. It is easier to double a business valued at $10 million than a business valued at $100 million. This potential can mean higher returns over time, and there is data to back it up. The S&P 500’s annualized return since 1989 is 9.5% while the Russell 2000 Value Index has enjoyed a 10.59% annualized return during that same time period. Potentially higher growth, however, means higher risk since the stocks of smaller, less well-known companies can be more volatile than those of larger companies.

4) Smaller companies are more nimble

In today’s fast paced environment, industries are constantly changing and businesses have to keep up. Large companies struggle to adapt quickly and see past their own systems and methods of thinking. Smaller companies tend to be more in tune with trends and have the ability to make shifts in their business models to capitalize on these trends. Being able to move quickly gives small companies an edge over their competitors as an industry evolves.

5) Traditionally lacking in a portfolio

Due to their higher risk profiles, many investors tend to underweight small cap value funds. Investors are often times attracted to large companies with long track records and stable growth. However, cutting out or even just underweighting an entire section of the market is never a good idea. A properly allocated portfolio should include funds with securities in all sectors and styles.

How Much Small Cap Value Should I Add to my Portfolio? 

As you can see small cap value companies can be a great addition to your portfolio, but they shouldn’t be the only thing in your line-up. Diversification across multiple asset classes and styles is very important, and there is no one right answer. Without a thorough review of your individual financial situation, it is impossible to determine your proper allocation. If you are interested in finding out if you are properly allocated, talk to your financial advisor. 

Value stocks can perform differently than other types of stocks and can continue to be undervalued by the market for long periods of time. Small-cap funds may be subject to a higher degree of market risk and are less liquid than large-cap funds or more established companies' securities.

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