As the risks get bigger, it’s time to think small.

In what’s shaping up to be a volatile 2023, small-cap companies are poised to bring both stability and growth to investors.

The line between small caps, mid-caps and large caps has shifted over time and varies depending on whom you ask, but today’s small caps generally boast market caps of $250 million to $2 billion. Companies below $250 million are commonly referred to as “micro-caps,” while the smallest of the bunch (less than $50 million) are considered “nano-caps.”

No matter where you draw the line, small caps offer a tantalizing benefit to investors: the prospect of higher returns than large caps.

Or as legendary Fidelity mutual fund manager Peter Lynch put it: “Big companies have small moves, small companies have big moves.”

A commonly used benchmark for small caps is the Russell 2000. This index reflects the performance of the smallest 2,000 companies in the Russell 3000, which consists of the 3,000 biggest U.S. companies, or roughly 98% of the investable U.S. equity market. The Russell 2000 comprises about 10% of the larger index’s market cap.

Small caps tend to be under-followed by Wall Street, which leads to investor neglect and undervaluation. When the investment community finally catches on, stock prices can move up in a hurry.

Geopolitical conflict and supply chain disruptions damage export-dependent giants, but they can actually benefit small caps. The majority of U.S. small caps derive the bulk of their sales domestically, which means that overseas wars and a strong U.S. dollar tend to hurt them less.

So far in 2023, small-cap stocks have outperformed large-cap U.S. equities. The benchmark iShares Russell 2000 ETF (IWM) has generated a year-to-date daily total return of 9.73%, compared to 5.67% for the SPDR S&P 500 ETF Trust (SPY), as of market close March 7.

Over the past 20 years, the IWM has outperformed the SPY to an even greater degree, 425.19% to 376.98%, as the following chart shows:

Source: Yahoo finance

After a strong start to the month, equity markets have lost momentum. Worries about “sticky” inflation and rising interest rates have recaptured center stage. But small caps can offer a refuge.

Powell spooks the markets (yet again)…

In his testimony to the U.S. Senate on Tuesday, Fed Chair Jerome Powell offered a downbeat assessment of the Fed’s success so far in fighting inflation.

“The latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated,” Powell said. “If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes.”

Wall Street didn’t like what it heard. The major U.S. stock market indices closed sharply lower on Tuesday as follows:

• DJIA: -1.72%
• S&P 500: -1.53%
• NASDAQ: -1.25%
• Russell 2000: -1.11%

The Dow Jones Industrial Average turned negative for the year and the S&P 500 slipped below the 4000 threshold. All S&P 500 sectors finished in the red.

Powell was on Capitol Hill during the first day of his two-day presentation of the Fed’s semiannual Monetary Policy Report, given in front of the U.S. Senate Committee on Banking, Housing, and Urban Affairs.

One wishes Powell were like, say, Gary Cooper: the strong and silent type. Powell on Tuesday once again demonstrated his uncanny knack for talking down the markets. His dyspeptic testimony reignited investor fears that interest rates will have to go higher for longer.

But here’s the silver lining: Slumps induced by Powell’s rhetoric are temporary and they create opportunities to purchase some good names that get clobbered pretty hard.

And here’s even more good news: Small caps historically outperform during inflationary and rising interest rate environments. That’s because smaller companies typically have low debt, making the risk of refinancing debt expense at higher rates immaterial.

In addition, small companies tend to be disrupters that operate in new markets where competition is initially low. They consequently enjoy the ability to raise prices easier than large caps, which paves the way for high profit margins.

Small businesses represent more than 99.7% of all U.S. employers. They employ half of all private sector workers. They account for up to 80% of the new jobs created annually in the country.

It’s a truism that small companies form the heart of the country’s job creation. They also generate breakthrough technologies.

Finding the next Apple…

The biggest stock market winners are companies like Apple (NSDQ: AAPL) that defy the status-quo and introduce disruptive new technologies that create entirely new industries and products.

Apple began as a tiny company, of course. It was the quintessential garage start-up. The legendary Cupertino, California-based tech firm now boasts a market cap of $2.4 trillion.

With over 2,400 stocks listed on the New York Stock Exchange and about 4,000 tracked on the NASDAQ composite, finding small stocks with huge potential can seem like finding needles in a haystack. It requires time, effort and expertise to uncover the small fry that offer exponential gains. To do this right, our team of Investing Daily strategists roll up their sleeves.

We pinpoint trends. We hunt for companies that are disrupting the marketplace. We dive into financial statements, analyze reams of data, and interview CEOs and company insiders. We even uncover nuggets of intelligence hidden in investor conference calls.

We take all this information, literally thousands of hours of accumulated data, interpret it and identify those companies that have the best potential of booking market-beating gains over the next year and beyond.

That’s where my colleague Dr. Joe Duarte comes in.

Dr. Duarte has been a professional investor and independent analyst since 1990. He is a former registered investment advisor and author of the bestselling Options Trading for Dummies, and several other books including Market Timing for Dummies and Successful Biotech Investing.

Dr. Duarte is the chief investment strategist of our premium trading services, Profit Catalyst Alert and Weekly Cash Machine.

In a new report, Dr. Duarte pinpoints a groundbreaking tech disruption worth $75 trillion…and it all starts with one under-the-radar small-cap stock.

This hidden gem of a company remains unknown to most investors, but it could very well become “the next Apple.” You need to act quickly, though. Once you start hearing this company’s name on the financial news, it will be too late. Learn more by clicking here.

John Persinos is the editorial director of Investing Daily.

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