The David vs Goliath metaphor is often used to describe improbable victories on the sporting field. At other times, it’s referenced to pit an individual against a big corporation.

But is this type of matchup relevant to stocks? Well, I think it is. History shows that smaller stocks often outgun their bigger cousins. And this has important implications for investors. It could change the way you structure your portfolio.   

Have a look at this:

The graph compares the performance of two US indices: the Wilshire Large-Cap Index (blue line) and the Wilshire Small-Cap Index (red line).

If you’re wondering what Wilshire is, they provide a range of indices to help investors analyse the US markets. The Large-Cap Index includes the biggest 749 companies by market cap, while the Small-Cap Index contains stocks that rank between 750 and 2,500.

Let me tell you a bit more about the graph. The start date is June 1978, and both indices have a base value of 100 (which allows for comparisons). Over the 43 year history, it’s the small-caps that come out on top.

But it’s not one-way traffic. You’ll notice that the two lines usually converge around the shaded areas. These are recessions, and they typically result in small caps falling further as business activity declines.

While small caps have generally done well during expansions, they’ll often do it tougher when the economic tide turns — greater potential typically brings greater risk.     

The outperformance of small caps can be traced back even further…

Research from US-based RiverFront Investment Group uses data going back to 1926. They calculate that after inflation, the trend in US small-caps has averaged 8.2% per annum.

So how about the Goliaths? Well, RiverFront put their average return at around 6.4% — nearly 2% lower. This sort of performance margin could make a huge difference over time.

No one can say if these trends will persist. The future could bring different rates of return. But I have no reason to expect that small-caps will lose their dominance.

What is a small cap stock?

The definition of a small cap stock varies. Take the ASX Small Ordinaries for instance. It’s widely used as an institutional benchmark for small companies. The index includes stocks in the ASX 300, but not the ASX 100. But with the smallest ASX 300 company worth around $1 billion, these are still relatively large businesses.   

Other definitions say that small caps are companies with market caps of less $2 billion. While others say they have valuations between $50 million and $500 million.

Whichever definition you prefer, small cap stocks are often invisible to most people.

Have a look at this:

Source: Market Index

These are the All Ordinaries top 10 performing stocks in the 12 months to June 2021.

Cast your eye down the list. Except for Seven West Media, most of the names are probably a mystery. Now have a look at the performance column. Any investor would like gains like these in their portfolio. Small cap stocks have upside potential that few stocks can match.   

And this makes sense. Many small cap stocks have a strong growth profile. That’s what often drives the share price. It can also lead to takeover activity, which produces further share price gains.  

Ask yourself this: Which stock is more likely to double in value over the next two years — a company in the ASX 50 or a rapidly growing small to medium size business?

The answer is obvious. You can see why smaller stocks have historically done well.

Finding the best performers

So does this mean you should simply buy any small cap stock? Absolutely not.

For every small cap stock that shoots the lights out, many more flop. A 2018 study by Handrik Bessembiner, a finance professor at Arizona State University, reveals a fascinating truth. He  found that between 1926 and 2015, the most common return for an individual stock was a loss of 100%. That’s right, a complete wipe-out! And of the 26,000 US stocks in the study, only 48% delivered any gains at all.

Stock selection clearly matters, as does a strategy to sell. So how do you sort high potential stocks from those that languish?

A strategy many professions use is to follow momentum. Rather than searching for bargains, a momentum strategy identifies stocks that are rising. And when you look behind the momentum, you can find some of the most interesting businesses.

Here’s an example:

This is a graph of an ASX small-cap: Mainstream Ltd [ASX:MAI].

Mainstream is a fund administration and share registry business. It has a market cap of around $370 million, but it’s not the All Ordinaries (the top 500 companies).

I suspect that most investors would have little knowledge of the company. I hadn’t heard of it myself. The stock only came to my attention last July when it appeared in my daily scans.

As I said before, momentum identifies some of the most interesting opportunities.

Mainstream’s shares are also benefiting from a takeover battle. This is an ever present possibility for small-caps on a growth trajectory. And it can be a source of rapid share price appreciation.    

Another advantage of momentum is that it helps avoid weak stocks. Remember the finding from Bessembiner’s research: The most common return for an individual stock was a 100% loss.

A momentum strategy can help avoid this fate. That’s because falling stocks don’t trigger a buy signal. If a stock is trending lower, you simply stand aside. 

Momentum changes can also guide your exits by helping exit declining stocks sooner. This means you’re less likely to get stuck with the worst performers.

Your edge in the market

Many retail traders see themselves at a disadvantage. They believe the big investment firms have more resources and better information. The little guy — they think — is always a step behind. 

But this is wrong. Retail investors have an important edge over the big firms. This is because they have less capital to invest. In turn, this makes it easier to take advantage of small-cap opportunities.

You see, a big fund can have difficulty trading smaller stocks. There simply isn’t always enough liquidity. This often results in a reliance on larger companies in the ASX 300.

There are over 2,000 listing on the local market. Of these, you’ll only find a small portion in the big indices. This opens a lot of possibility for the retail investor who knows where to look.

*Jason McIntosh is the Founder of Motion Trader. He began his career in 1991 on the trading floor at Bankers Trust. After leaving the bank in 1999, he co-founded two stock advisory services and a funds management business.

Nowadays, Jason trades his own algorithmic systems from home in Sydney. He also shares his three decades of experience via Motion Trader — an investment service that uses momentum strategies to identify opportunities from over 2,000 ASX stocks.