In this week’s episode of Retire in Texas, Darryl Lyons, CEO and Co-Founder of PAX Financial Group, explores the world of small-cap stocks and their potential role in your investment portfolio. While often overlooked, these companies present unique opportunities for growth – but also come with specific risks. Darryl unpacks the fundamentals of small caps, their historical performance, and key factors influencing their future outlook.
Key highlights of the episode include:
• The definition of small-cap stocks and why they differ from traditional small businesses.
• How small-cap companies fit into a diversified investment strategy, typically making up 5-15% of a portfolio.
• The impact of interest rates on small caps and why rate cuts could create a tailwind for these stocks.
• Why private equity is changing the small-cap landscape and what that means for investors.
• Examples of small-cap companies that have grown into industry giants, like Monster Energy and Pilgrim’s Pride.
• The pros and cons of investing in small caps, including their potential for high returns and their vulnerability to market swings.
For additional insights and to learn how PAX Financial Group can guide your financial journey, visit http://www.PAXFinancialGroup.com. If you enjoyed this episode, share it with someone who could benefit!
Transcript:
Hey, this is Darryl Lyons, CEO and Co-Founder of PAX Financial Group. And you’re listening to Retire in Texas. This information is general in nature only. It’s not intended to provide specific investment, tax, or legal advice. Visit PAXFinancialGroup.com for more information.
Okay, so I want to talk about something that, for me and my podcasts, like there’s this, “I love this podcast. This podcast is going to change people’s lives.” Like, I really get passionate about it because of the substantive nature of a podcast. But this one’s I’m like, this one’s just like a small one, like, and I say that kind of tongue in cheek because if you don’t listen to this podcast, your life will still be okay.
There are some other podcasts, like, you really got to go back and listen because it was good stuff. This one is just like – meh. But I think it’ll help you because I’m going to talk about a very tiny segment of your investment portfolio that if you just pay attention to it, you might make more money. And I think you want to make more money.
Then you’re like, well, wait, I could go do a side hustle or I could find other ways to make money. But you know what? You could find the hard way, or it’s a little easier to just make these marginal improvements in your investment portfolio. And you can make money that way. So, I’m going to show you how to do that.
So, I’m going to talk about small company stocks. I’ll start out with a quick story. Whether it’s true or not, I don’t know, but a successful small business owner, he was constantly in demand for after dinner speeches but never had time to prepare. Never. He’s always too busy. His assistant, she was kind of frustrated with this, but she always wrote his speeches for him.
So, at this annual conference, he stood up and began his speech. Ladies and gentlemen, there are three main areas of tension in today’s small business. The first is the problem of not paying competitive salaries. Then he turned the page and read. From now on, you unappreciative pig, you’re on your own. I think it’s funny. The moral of this story is, look, this is small business.
So, when we talk about small companies, we’re talking about small businesses that can be impacted with employment changes, leadership changes, cash flow changes. Like all the disruptions that a small business might have, small companies have. The only difference is the size. And that’s where I want to kind of make sure that we distinguish here. When I’m talking about a small business, usually I’m talking about somebody like PAX.
It’s a small business, with 26 employees, maybe an accounting firm, maybe, you know, I’m thinking of a little store, like a convenience store or a taco shop, you know a small business when you see it. These are small companies. So, it’s typically measured by capitalization. So, this is important, I think, for you just to have in your education repertoire.
When we say small cap stock, what we’re saying is, you take cap is the total number of shares outstanding. Remember, shares are the ownership of a company. So, we used to have pieces of paper. Now it’s all electronic, but all the shares that you have outstanding. You multiply that times whatever the price is on Yahoo Finance. So, if it’s $20 a share, times all the shares that are outstanding, that’s going to be what they call capitalization.
They shortened it for cap. So, when you hear small cap that’s how it’s valuing that. So small cap companies are valued between 300 million and 2 billion. So still big companies. But just not the small mom and pops anymore. There’s still some complexity to them. In fact, they get their own special category. So, you’ve heard of the Dow, the Dow Jones Industrial, and you’ve heard the S&P 500 often use their indices that measure the health of the economy.
There’re actually special indices that’s manufactured by this company called Russell. And they take instead of the Dow takes 40 stocks and the S&P 500 – 500, actually it’s 498, but 500. And then Russell takes 2000 companies to give all of us as investors a sample size of the small cap market. So, there’s 2000 companies represented here.
So, if you came to me and said, Darryl, I really want to own small cap companies, but I don’t know which one to buy. I’d say, well, you can buy the Russell 2000 and just kind of own a bunch of them. So that way if one goes bankrupt, you’re okay. So, it’s the Russell 2000 that represents the small cap companies.
So, if you look in your investment portfolio, in your investments either with PAX, your financial advisor, or your 401K, you’re going to look in there and you’re going to typically see between 5 and 15% of your money in small caps. And you’re asking, is that good or bad? If I’m on the low end or high end, it really depends.
I’ve actually seen as high as 25%. I personally love small caps. I think they’re good for you. I think it’s the aggressive piece that you need for your portfolio. I think 5% is kind of low, but you know, that’s just me. I think, you know, from a professional compliance perspective, it certainly depends on your risk profile, because they do have some risk and, you know, they’re smaller.
So, they’re not the AT&Ts, they’re not the too big to fail banks. They’re smaller, they can fail. There are many examples I give you. Let me give you a handful, BorgWarner. They make auto parts specifically for electric vehicles. But let’s say you go I don’t really want to own Tesla, but I still want to kind of be on that EV niche.
Then you could own this company, and they make the parts for electric vehicles or New-Skin. That is, you might be familiar with them. They do global personal care and wellness. They’ve got a really strong customer base. Another example would be Pilgrim’s Pride Chicken. So not a huge company, but pretty stable. People are going to eat chicken and they’re going to continue to eat chicken.
I’ll give you one more example, but there’s this company that’s now big. But they were an energy drink. They were a small energy drink at the time. They had a niche they focused on, you know, these college students that were staying up late, studying with air quotes. And they were just really brilliant in their marketing. The can design and then they just became a household name.
Now they’re worth billions. And that was Monster. And we all would have loved to have invested in them when they were just a small cap company, a small company. And that’s what makes small cap companies cool, is they’re small companies that end up becoming bigger if they do well. So, let’s break it down real quick.
Should we own small caps? I already told you you’re going to own them. Generally speaking, between 5 and 15% in your portfolio just as a result of being diversified. But let me give you the pros and cons real quick of owning them. So, the pros let’s go there first. First of all, small companies have this room to grow.
This room to really expand. And there’s some good research done by these, Nobel laureates, Fama and French, well known in the industry out of Chicago. And if you think about the general stock market environment, think of it like an ice tray, and you diversify and you fill the ice tray with water about three quarters of the way full.
And so, what Fama and French would suggest is that you can’t really ever outperform the markets because there’s so much information that by the time you have insight, it’s already been accounted for in the price of the stock. That’s called market efficiency. But what they do say is that you can tilt the ice tray just so just a little bit towards small caps and enhance your returns.
And so, they rely on a lot of historical data to support that hypothesis. And they’ve become kind of a staple in the industry. There’s a company out of Austin, Dimensional Funds, that built their whole business around Fama and French’s research. So, a pro for investing in small cap companies is if you buy into Fama and French’s research, then you would say, yes, small cap companies, because they have more room to expand.
They will grow faster. And the research is supported, from 1963 to 1990. Small caps, these small cap companies actually outperform the market by a good 3%. So, I mean that is strong compounded returns over time, solid. A part of the reason, and this is another advantage, or pro of small caps. One of the reasons is a lot of these big analyst investors, they cover the big companies like Apple and Google.
And you turn on the TV and you’re always going to talk about the big ones. So, there’s not as many people that do deep coverage on these smaller companies. So, if you find yourself doing research on these smaller companies, you can find little nuances like, oh, they just got a contract with the federal government, or they just hired this new CFO that’s very successful.
You can learn, this is the theory on small caps. The information is not as prevalent in these smaller companies. So, you can gain insight and be able to buy companies before these insights materialize into the price of the stock. So that’s one of the pros in theory, that you can buy small cap stocks. And often you and I are going to necessarily do that homework.
But these fund managers or there’s a bunch of fund managers out there, I think I’m not like, promoting anybody. But I always think of like Zack’s or Royce. These managers historically have been like hyper focused on small caps, and they look for these little inflection points where the market hasn’t priced in something good in the small cap space, and they buy it on behalf of our clients.
Interest rates actually are an interesting play right now because if interest rates go down, a lot of people, this is a big talking point on Wall Street. A lot of people believe that if interest rates begin to get cut, that’s going to be a huge tailwind for small cap stocks. So that would be a pro. If you’re pro small cap stocks, you would say, I’m making a bet for lack of a better word.
Now we don’t bet in investment business because we’re long term. But for lack of a better word, you’re saying like when interest rates go down, I’m going to make money on small cap stocks because the idea is, is that interest rates are really, really a lot of pressure for small companies because they borrow money. And when they borrow money, you have to pay high interest rates.
That puts a lot of pressure on their cashflows. So, when interest rates go down, their debt that they’re servicing is small company debt service is more manageable. And so, a lot of people who are excited about small companies, they’re just waiting for interest rates to go down. There’s also reason to believe small cap companies will do well in the future because of the new government.
So, these policies that we’re seeing, or at least being discussed in the Trump administration, encourage innovation that may give them an extra boost that can stimulate growth. The effects of tariffs will help this idea that small companies that generally don’t have a global footprint, that expect to sell a lot of their products and services domestically.
They will benefit from a Make America Great Again agenda with tariffs on international companies. Small companies will be a benefactor of that. That’s one of the theories. And I think there’s a lot of reason to believe that. I mean, the Federal Trade Commission is making an aggressive push for more innovation.
And that helps small cap companies, for sure, you can even make a case that the whole administration, including RFK, may help, but when he first, this is just a side note, when he first was being considered, if you look back, the small cap stocks had a huge sell off, specifically in health care and biotech because people got concerned about his relationship with big pharma.
So, you can look back and say, oh, I don’t want to own small caps because of RFK, but that sell off has occurred. It may be a little bit more stable now as people are getting better information. I would suggest to you that if long term irrational innovation in the Department of Health and Human Services that encourage drug discovery and encourages innovation that saves lives will actually bode well for small companies.
So, I don’t see RFK as a problem for small companies, but there’s probably plenty of research that can help you if you want to dig into that. But generally speaking, I’d say the administration being a Make America Great Again agenda would probably do well for small caps. Now let’s talk about the risk of small caps.
Again. I talked about the debt. They tend to borrow more. So, as interest rates have gotten up, that puts pressure on them. So, that’s why small company stocks over the last several years haven’t done as well as because interest rates have been going up. But not only that, I was looking at some charts and if you compare the debt loads of these small companies compared to large companies, the small companies have been taking on a lot more debt.
So, not only is the price of debt gotten higher, but they’re taking on more debt. So, that is a little bit of a concerning trend in the small cap space. Now historically, the small caps have more swings in general. So, that’s just a negative by their very nature. And so, you just have to know that you’re going to have to weather those ups and downs.
Also, small caps, sometimes before they materialize to get their full, full potential, they get gobbled up by the bigger companies like Google and Facebook. They acquired over 350 of these companies since 2000. So, right before you’re an owner, so let’s say you’re an owner, right before you’re going to get to enjoy the benefits of these companies’ innovations, they get gobbled up by the big ones.
And that doesn’t help for small company stock shareholders necessarily. And then again, you have the more recent years. I know you have those 30 years I mentioned earlier that did real well for small caps, but really over the last, I guess decade or so, they’ve underperformed. It’s been several decades, I should say.
And I’ll put the data points in our show notes if you want to look at that. But small caps, you know, I mentioned that from 1963 to 1990, but since the 90s or so they’ve underperformed large caps. So, you’d been better off not owning any, which is kind of disappointing because that’s not the way it’s supposed to be.
Small caps have more risks. You’re supposed to get more return. I’m going to tell you why, though. Because I looked into this. There’s a reason why. More companies are staying private for longer. So, the environment, this is important. The environment for capital, for money to grow has changed. Now private equity firms and venture capital firms, there’s so many more that, hear me out.
The total number of publicly traded stocks has fallen since 2000 by nearly half, and most of that has come from these small companies. So, most companies do not even go public anymore. They don’t want to. It’s like, they’ve got to deal with DEI, ESG, regulatory stuff. And don’t think I’m being political here.
This is real. Like the regulatory burdens that’s been put on small caps over the last several decades, they’re just like, I don’t want to do it. And so, they stay private for longer. And so, if you’re really, really good company in the small cap space, you’re not going public. So, as an investor, you’re like, well, Darryl, that stinks.
I want to like, you’re saying only rich people are getting the private equity, and not the general public anymore. Yes, I will tell you that. And PAX is in on this as well. If financial advisors, us included, are now tapping into private equity because we’ve seen this and maybe even we’re late here, but we’re tapping into private equity for our clients, much more access to private equity for you as an investor has gone up considerably more.
The access points, it’s much easier to get private equity than it was even five years ago. And so, I don’t think we’re late to the game. We’re probably even early innings. But now, if you’re working with your financial advisor, talk to them about the small cap space and the pressures that exist there and ask them, hey, I still want to own small companies, but can I own them as a private equity owner versus a publicly traded owner?
And that, to me is a strategy worth wrestling with your advisor. And so that’s, I think if I could summarize my position on small caps, I think small caps, by the very definition of being innovative companies that are nimble enough to grow are an awesome opportunity. I just think that going forward, owning them as a private equity position versus a publicly traded position might be what we see in the future for us to capture those returns again.
That said, the same returns that Fama and French had recognized from 1963 to 1990 can still be there, but it might have to be packaged as a private equity company. Okay, so I said all that, and I said, look at the very beginning, this isn’t a game changer in life. It’s not. But really, if you just think about this little position just a little bit, I think you’re going to find you’re going to be able to pick up pennies and dollars, and eventually those things add up over time.
And I do want you to win with money. And I think that you can win with money by owning good companies over an extended period of time. And this is one way for you to do that. And so, if you continue to just make modifications, gentle modifications, not, you know, not switching money lanes, I think you’ll win. And I think small caps and small companies generally, if you own them over an extended period of time, should reward you and help you meet your goals.
And as always, you think different when you think long term. Have a great day.
Resources:
10 of the Best Small-Cap Stocks to Buy Today | Morningstar
(9) Have the insatiable private markets eaten the small cap effect? | LinkedIn
StepStone PowerPoint Presentation Template_Jan 2024
The stars appear aligned for small caps
The best and worst Small Growth funds
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