Why should all investors have an allocation to small cap growth stocks? There are three main reasons. First, small caps outperform the market in the long run. Second, this sector provides access to exciting new opportunities before they become household names. And third, innovative ideas, which are an important driver of our economy, are more prominently featured in small-cap growth portfolios.
Innovation can lurk in smaller companies
The small cap sector, in particular small cap growth stocks, includes companies that are not yet well understood by the market. We often invest in companies that many people have never heard of.
Focusing on innovation and investing in companies that spend a high percentage of their revenues on R&D can be a useful strategy over the long term. Companies with a high level of intellectual capital tend to be less cyclical and that capital -- patents, trademarks, ideas -- gives them a bigger moat to defend against competitors. Particularly in tech and healthcare, firms with high R&D expenditures tend to be less cyclical, because what they provide is disruptive. Even in a no-growth world, these companies are able to drive wallet share and revenue growth, often at the expense of incumbents.
Innovation has been and will continue to be an important engine for economic growth. Innovation drives productivity — to be able to do more with less. We want to do things faster and cheaper. Productivity gains help sustain stronger GDP growth for longer.
Much of the productivity gains in the recent past have come from better technology, which is becoming a bigger and bigger part of our everyday lives. When was the last time you used a paper map to navigate? Remember you used to get the weather forecast from the newspaper? Less than ten years since the introduction of the iPhone, the digital camera has more or less disappeared from your vacation packing list. The rapid pace of innovation means the pace of disruption is accelerating. It is not unreasonable for technology to become a larger weight in the benchmark. Technology is the industrial revolution of the 21st century.
In the 2000s, we built pipes -- fiber optic cables -- and networks. “To Google” became a verb. In the 2010’s, we experienced mobile computing and the proliferation of the smartphone. Now, in the 2020’s, we’re seeing continued migration to the cloud and utilization of big data and AI for every industry vertical: self-driving cars, new insurance products, and digital advertising.
How to manage small cap investments for your clients
There is tremendous opportunity for a skilled active manager to differentiate winners from losers. It is important to have a small cap growth allocation in every portfolio so one can benefit from these exciting emerging investment ideas. It is even more important to pick an active strategy that focuses on identifying the disrupters and avoiding the disruptees.
Behind every trade lies risk. Advisors should consider their partners carefully.
If you’ve decided to recommend small cap exposure to your clients, there are several ways to go about it. Small cap as an asset class is much less efficient than large cap. I would not recommend a small cap ETF. By buying an ETF, you are essentially buying every name in the index — including the ones that are experiencing secular challenges or being disrupted by innovators. A skilled manager, on the other hand, is able to differentiate the winners from the losers. As an advisor, you can get your clients into small cap growth stocks through an actively-managed mutual fund, a separately-managed account, or your own portfolio-management strategy.
During these times of uncertainty, it’s important to remember that we should always take a long term view of investing, whether it’s large cap or small cap, without trying to time the market, which often doesn’t work. Depending on your clients’ risk tolerance and time horizon, you should allocate a portion of their portfolio to small cap and rebalance from time to time.
Remember: healthy pullbacks in the market are normal. They provide us with buying opportunities to lean into our very best ideas. Even though the broader indices have recovered nicely since the pandemic began and even made new highs, we are potentially entering a period with stronger than expected growth driven by the aggressive stimulus that’s been injected into the economy.
The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
