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Small cap recap

Small-cap equities can offer a U.S. orientation for investors skittish of overseas markets, but they come at a cost, Brian Kilb explains in a Money Talk Video. A transcript of the video interview with Joel Dresang follows.

Joel Dresang: Brian, we’ve talked before about small-cap stocks. They’ve been in favor lately because the domestic stocks have been rising and the international market hasn’t been as good, and small caps typically focus more on domestic issues, right?

Brian Kilb: Well, the positive is that small cap companies, the smaller guys, typically don’t do a lot of business overseas. Given the strength of the dollar, the dollar itself has appreciated against the euro almost 20% since last spring, and to a significant degree against a basket of world securities. So, to the degree you have that foreign business, oftentimes it’s been a detriment to your overall profitability. The small caps mostly avoid that trap by being contained domestically.

Joel: What about the valuations for small caps?

Brian: Now we’re onto the con side of things, right? The bad news is small caps are pretty expensive right now. Even after a challenging 2014, the price-to-earnings ratio for small-cap stocks is roughly 24. Compare that to the forward P/E on the S&P 500 right now, Joel, which is around 17, you can see that there’s a pretty hefty premium for owning small-cap stocks right now. As a rule, I typically don’t like to buy expensive things. I like to buy things cheap.

I think the other thing you want to know about the small caps, Joel, is typically in a rising rate environment, it’s more challenging for the smaller companies. The smaller companies that have debt, oftentimes it’s variable debt, so as interest rates rise, that burden on the smaller companies can be significantly greater for the little guys than it is for the bigger guys

Joel: What are the merits of having small-caps in your portfolio?

Brian: Well, typically in the beginning of a business cycle, the small caps are nimble; the small caps, the companies are able to move quickly and take advantage of rising economic tides. It’s debatable where we are in this business cycle, but we’re somewhere in the middle to the second half, when the large caps typically take over. When you combine the fact that the larger companies are cheaper, and we’re in the second half of this business cycle, it would tend to make you want to think that maybe there’s better opportunities elsewhere.

Joel: And you’ve pointed out in the past that small caps tend to be a little more volatile. So they’re not always appropriate for retirees.

Brian: It’s a big rollercoaster ride, Joel, and there may be a point in time for any investor where they’re just not comfortable with the rollercoaster ride. So consider whether it’s worth making a teeny bit more for the extra risk you’re taking. Most often, people will not take that tradeoff in their later years.

Joel: But still, they have a place in most diversified portfolios?

Brian: But again, nothing’s for nothing. Make sure you understand the risk involved with the potential reward. I think earlier on in years, small caps make a good complementary position in your portfolio. I don’t know that in the distribution phase of your investment life that you need to put up with that kind of rollercoaster ride.

Brian Kilb is executive vice president and chief operating officer of Landaas & Company.

Joel Dresang is vice president-communications at Landaas & Company.

Money Talk Video by Peter May
(initially posted Feb. 26, 2015)

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