If you are risk-averse and have been resisting small-cap stocks, you’re missing out, according to asset manager Don Klotter.

“What we have shown over time is that the bigger risk is if you’re sitting on the sidelines and sitting there on cash,” said Klotter, the managing director, and head of EFG Asset Management in North America. “You’re going to miss out on this opportunity, which over the longer term we have been able to see that small caps have returned better than just about any other part of the equity spectrum."

Klotter said that going back to the 1930s on an annual basis, small caps “are the only asset class that has outperformed inflation every decade. And this is because it involves smaller companies that tend to grow more rapidly than their original universe."

Small caps, tracked by the Russell 2000, have evolved and have gotten larger over the years, Klotter noted. Nowadays, he said, they have a market cap between $500 million and probably $6 billion or $7 billion. “But if you would have asked me 15 years ago, I would say a small cap is basically $300 million up to $3 billion.”

Klotter said that the definition of small caps at the moment is driven by what the market is representing, and the average small cap has a market cap of somewhere between $3 billion and $3.5 billion. “We call them small caps in U.S. context only because they’re small relative to Amazon and Apple,” he said.

“But the reality is if you are talking about a $3 billion, $4 billion or $5 billion company, that doesn’t necessarily mean it’s a small company,” he said. As an example, he said that Credit Suisse as of a couple weeks ago was a $6 billion market cap company. “So, it doesn’t necessarily imply it’s small, it just means relative to the rest of the universe.”

In today’s inflationary environment where a lot of people are concerned, Klotter said you want to have exposure to an area that has the potential to grow rapidly, which is what small caps offer. Small cap stocks have some of the most exciting, interesting and innovative companies that are fast growing, Klotter said. The biggest sectors in the small caps growth space, he said, are technology, healthcare and consumer discretionary, which includes areas such as retail stores and restaurants. 

“And from our perspective, what makes things really interesting is that when you have times of stress like we have in the market right now and you have slow growth or no growth, that doesn’t mean that you have no smaller companies that are growing very rapidly,” he said. “In fact, what it tends to do is it puts pressure on everybody in the market and you see a much broader dispersion between winners and losers.”

He cited Apple as an example of a company that did not experience the Great Recession like others did. “So, even in very difficult times there are companies that do grow, and they do grow pretty dramatically. There are less of them so there becomes a scarcity value,” Klotter said.

Klotter said the Russell 2000 historically has about a quarter to a third of companies that are not profitable, but that number has risen and is probably about 45% now, which highlights the pressure on the market “and makes it very clear that the winners are going to win, and the losers are going to be punished as a result.”

As the winners eat up more and more of the market share, it’s not surprising to see some companies drop out of the index, and you get more and more investors chasing the winners, which raises the importance of the scarcity value, Klotter said, adding that there is also an emphasis on quality as more investors seek smaller high-quality small-cap companies.

Klotter also pointed out that over the past few years small caps have been viewed as a much more “inefficient space” relative to large caps because there is ample information available on large caps. “You’ve got tons of people on Wall Street that are covering every company, they are analyzing theme writing it up, and in the case of small caps that’s not always true,” he said. 

But he said over the past few years and through the pandemic, a lot of Wall Street firms have cut back on their coverage, but they seem to have increased staff covering some of the smaller-cap companies, he said.

Still, the spotty coverage of small caps, Klotter said, is a good thing for asset managers because it creates opportunities that are not widely known. “And when you’re able to do that, then you have the great opportunity to create dramatic growth,” he said. But Klotter added that it is important that you are an active manager or involved with one that is doing fundamental research and not just investing in their best ideas within that universe.

“Again, I think small caps are a great opportunity because there is less efficiency. There’s a load of companies in the small-cap universe, and if you can identify the best of them, then you can really take advantage of some significant growth,” Klotter said.