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Finding Good Stocks in a Bad Sector

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Whatever happened to small-cap stocks? The argument for smaller companies used to be simple: Their shares are riskier, on average, than shares of larger companies, but they return more to investors. So, more risk, more reward. That’s a rock-solid principle of investing (and of life, for that matter). Though small-cap stocks may be too volatile for some investors, a small injection of small caps can give a portfolio a nice boost.

One advantage of a stock with a small market capitalization (defined as price times shares outstanding) is that, being small, it may elude the attention of analysts and most investors. Such a stock can be an overlooked bargain. Another plus is that, with a small cap, you have a chance to make gigantic returns on your original investment. If you had bought Netflix (symbol, NFLX) in 2008, when it was a small-cap stock trading at about $4 a share, and you had held it until today, you would have increased your initial investment by a factor of more than 100. If you buy Netflix today, as a mega-cap stock trading at $495 per share, that kind of return is unimaginable—its market cap would exceed the current gross domestic product of the U.S.

(By the way, there is no official definition of a small-cap stock. Some experts put the market-cap limit at $2 billion, but the largest firms in popular small-stock benchmarks have market values of $4 billion to $5 billion.)

Large-cap dominance. Despite their benefits, over the past five years, the annual average return of small caps has been roughly half the return of large caps. Large-cap stocks have beaten small caps in five of the past six full calendar years since 2014—and so far in 2020, it has been a massacre. Through August 7, SPDR S&P 500 (SPY), the popular exchange-traded fund linked to the S&P 500 large-cap index, returned 5.0%. But SPDR S&P 600 (SLY), the small-cap ETF, declined 9.8%. (The small-cap ETF is also one-third riskier, according to Morningstar data.)

Investors, naturally, are turned off. The S&P 500 ETF,........

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