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Small-cap investors know bigger not always better

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BOSTON (AP) -- Bigger usually offers more protection than smaller. Think of boats in rough seas, or planes in turbulence.

Typically, that's how it is with investing, too. Bigger companies have more cash flowing in and broader product lineups than smaller ones. So they've got more of a cushion when the economy trips up, which insulates their stocks.

This year, the gains investors enjoyed in 2009 are under siege.

Yet stocks of bigger companies aren't offering greater safety. The large-company Standard & Poor's 500 index is down 4 percent, while the S&P Small-Cap 600 index is up nearly 3 percent. And mutual funds specializing in small-cap stocks fared better than large-cap stock funds through the first half of this year, according to fund tracker Lipper Inc.

Small-cap companies - generally, those with a market value of $300 million to $2 billion - are faring relatively well because they typically do most of their business in the U.S., and aren't yet big enough to venture into Europe. The continent's economy is currently stalled by fallout from the Greek debt crisis.

As a result, many large-cap companies - those worth $8 billion and up - have been hurt because they rely heavily on European sales, notes Charles McQuaid, co-manager of the Columbia Acorn Fund (LACAX).

Europe's troubles are one reason why the $14.4 billion fund has recently replaced many of its large and mid-sized stocks with small ones, a strategy McQuaid calls "smallification."

One of its recent top smaller-company holdings: Lululemon Athletica Inc., a yoga apparel retailer whose stock is up 31 percent this year.

McQuaid points to two other catalysts for small-caps: They've recently enjoyed stronger earnings growth than larger companies, and enjoy brighter expectations for the next 12 months as well. And small-caps could increasingly become buyout targets of bigger companies looking to dip into cash hoards that have become flush during the recession. Stocks of acquisition targets typically surge when deals happen -- sometimes even before, on speculation.

"As big companies' balance sheets go from good to great, and as confidence improves, we will see more takeovers," says McQuaid, who figures small-caps will maintain an edge a while longer.

If he's right, they'll extend a hefty competitive advantage over the last decade. The S&P Small-Cap 600 finished up 68 percent. The large-company S&P 500? Down 24 percent. That means, excluding dividends and expenses, a $100,000 stock portfolio in the small-cap index would have grown to $168,000, while a large-cap portfolio shrank to $76,000.

Still, small-caps shouldn't make up the core of a well-rounded portfolio. Less-volatile large-caps are a better fit, which is why S&P 500 index funds often serve as the foundation of 401(k) accounts. Yet those S&P 500 funds are void of small-caps, meaning you could miss out on some strong long-term gains.

If you're weighing how heavily to invest in small-caps, some key considerations:

Expect a bumpy ride

Smaller companies often grow faster and fall harder, and that's reflected in their more volatile stocks. So you've got to accept choppiness -- typically not a big deal if you're a young investor, but perhaps an issue if you're older.

Typically, expect small-caps to rise or fall about 20 percent more than the broader market -- for example, if the S&P 500 falls 5 percent, a typical small-cap might lose 6 percent.

Don't get overexposed

Small-caps are a tiny market segment compared with large-caps, and their footprint in your portfolio should be sized accordingly. The Russell 2000 index, which reflects a broad segment of the small-cap universe, represents just 8 percent of the U.S. stock market's value. By comparison, the S&P 500 accounts for about 75 percent.

An investor seeking to mirror the stock market should probably use the Russell 2000 as a guide, meaning small-caps should make up 7 percent to 9 percent of a stock portfolio, according to Tom Idzorek, chief investment officer with the asset allocation research firm Ibbotson Associates.

Someone with higher risk tolerance and a few decades until retirement might consider 10 to 15 percent, while someone near or in retirement should be around 5 percent.

Look elsewhere for dividends

If you're retired or otherwise need steady income, dividends are your friend. You're less likely to get them from small stocks than from large ones. Bigger companies are more likely to share profits with investors through regular payouts, rather than plowing cash back into the company to fuel growth.

Capitalize on uncertainty

Where there might be dozens of Wall Street analysts following a big stock, small-caps could have five or fewer, or even none. With less publicly available research, there's a greater chance that a small-cap's stock price doesn't accurately reflect the company's true prospects.

That creates opportunity for fund managers skilled at identifying bargain stocks. A small-cap manager's skill may translate into a bigger performance edge than you'd get from a strong large-cap manager. The bigger the stocks, the tougher it is to identify hidden gems and outperform an index fund.

One related small-cap advantage: research access. Steve Gutch, co-manager of the Federated Clover Small Value Fund (VSFAX), says executives at the predominantly small companies he tracks give him far more freedom than large-cap managers researching big companies.

"You're able to speak not only to the management team, but to the people who work in the divisions," Gutch says.

...And the recycling opportunity

The indexes that small-cap managers explore for bargains regularly winnow out stocks that become too big and graduate into the mid-cap ranks. They're replaced by micro-caps that become small-caps.

Typically, companies enjoy their most dramatic growth when they're small. So buying stocks of companies that are growing at their fastest pace can boost returns more than buying when their best days are behind them.

Remember: Even Walmart and Apple were once small-caps. You probably missed out on those opportunities, but there could be stars-in-the-making in today's small-cap universe as well.

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