Avoid the garbage in your small-cap index fund

Avoid the garbage in your small-cap index fund

There’s a reason I’m always pounding the table about small-cap stocks…

They’re often the fastest-growing companies and the most underpriced. That makes small caps a great place to hunt for extraordinary gains.

So, I’m not surprised when readers ask, “Can’t I just buy a small-cap index fund?”

  • Well, let’s look at what you get with a small-cap index fund…

The Russell 2000 is the main small-cap index. It consists of the smallest 2,000 stocks in the Russell 3000. Meaning it’s more or less the smallest two-thirds of the stock market.

There are several easy-to-buy funds that track the index. So, that’s how many investors get small-cap exposure.

The problem is, the Russell 2000 has only done so-so for the last five years. It’s risen 106%, which isn’t terrible. But it’s worse than the overall market, which has climbed 138%.

That’s the trouble with buying the whole index. You spread your bet across 2,000 companies. So, you get the high-growth small caps you want. But you also get a lot of garbage. And the combination hands you ho-hum returns.

  • Wouldn’t you rather sidestep all the lackluster companies in the Russell 2000?

Like OceanFirst Finanancial (OCFC), for example. It’s a New Jersey-based community bank, and I’m sure it’s a perfectly fine company. But the stock, which is part of the Russell 2000, has gone nowhere in the past five years.

The Russell 2000 is full of stocks like OceanFirst. In fact, 22% of the index is banks, REITs, and financial stocks. These are rarely high-growth companies. And growth is what you need for higher returns.

Just look at Pennsylvania-based S&T Bancorp (STBA). Again, it’s probably a decent company. But it’s still trading around $31 a share—right where it was in 2003.

  • Banks aren’t the only laggards in the Russell 2000.

Beverage company NewAge Beverage (NBEV) has tried and failed to reinvent itself multiple times. Its financials are a mess—the company couldn’t even file its 2020 annual report on time.

And the worst part is, its stock has gone nowhere in 5 years. It’s trading around $1.60 today—right where it was in 2016.

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NewAge Beverage is the sort of company I like to avoid. But you can’t when you buy the whole Russell 2000. The index is packed with others just like it—small caps that go nowhere (or worse).

  • This is why I spend most of my time digging into individual small-cap stocks.

Regular readers know what I’m looking for...

  1. Cheap (underpriced) small caps

  2. With little to no debt

  3. Strong insider ownership

  4. And rapid growth potential

I pay extra attention to small caps with unique catalysts that could propel their stock prices much higher. In the case of Vistra Energy (VST), which I recommended in July, that means recovering from a fluke storm. (It’s still a buy at current prices.)

For Franchise Group (FRG), which I also recommended in July, the catalyst is new deals. CEO and major shareholder Brian Kahn continually buys up undervalued franchises to roll into the company. In fact, he announced a new $80 million deal to buy tutoring company Sylvan Learning a few weeks ago. And the company just put out fantastic third-quarter earnings. (FRG is still a buy, too.)

  • I am always bullish on small-cap stocks.

But buying a small-cap index fund will only get you mediocre results. We want more than that here at Smart Money Monday­­—we want the small caps positioned to explode higher… and none of the garbage.

In the coming weeks, I’ll share more about my strategy for pinpointing the most profitable small cap opportunities. Stay tuned.

Thompson Clark

—Thompson Clark
Editor, Smart Money Monday


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