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While the rest of the market is busy worrying about the short term outlook for the economy, I prefer to focus on something we can do something about. That is, I want to focus on the basics and look for companies that have the potential for strong returns in the future. As a long term investor, I believe that small cap stock investing is a good way to add above average returns to a diversified portfolio.

Measuring Small Cap Performance

It’s important to compare the performance of your portfolio to industry benchmarks (in order to see how it is really performing). Remember, in the stock market there is no free lunch - when you invest in smaller companies you have the potential for strong returns, but also for large losses. This is why returns on these stocks are generally higher. So, if you are underperforming major small cap indexes, then you may be getting too little return for the level of risk you are assuming. The industry standard for comparing small cap performance is the Russell 2000 Index (^RUT). Over the last 5 years, it has returned 15.3% annually vs. 12.6% for large cap stocks. Further, growth and value indexes for the Russell 2000 also track performance by investing style (ticker for Russell 2000 growth index is ^RUO, ticker for the value index is ^RUJ).

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It seems like investors are inundated on a daily basis with short term market headlines (especially now). This information, while useful and important, can be overwhelming and distracts from the most critical aspect investors should focus on: long term investing. The fact is, trying to time the market in the near term is an extremely difficult undertaking - one that many money managers fail miserably at. Still, many investors try their hand at market timing and ultimately lose money.

Small Cap Stock Investing as a Long Term Play

As an alternative, investors should focus on the long term while taking into account their risk profile. Investing in a diversified portfolio of small cap stocks can yield above average returns over the long term. Long term means 5-10 years, period (don’t kid yourself - be realistic about your capital requirements). However, I do not recommend that investors close to retirement or with near term financial responsibility (debt, children, college, etc.) maintain a large position in these types of stocks.

Don’t Be Myopic

In 2007, large cap stocks outperformed mid-cap and small cap stocks (this trend will likely continue). However, the good thing is that short term focused investors will neglect out of favor small and mid-cap stocks as a result. This could present a buying opportunity for long term focused investors.

The Value Proposition

Bottom line: small caps as measured by the Russell 2000 have outperformed large caps (Russell 3000) over the long term (see graph). There are several reasons for this. For example, small cap stocks typically experience higher variability in near term returns - this “risk” is essentially the trade off (remember, there is no free lunch on Wall Street). However, if we are focused 5 to 10 years in the future, we shouldn’t care what the 1 year or 3 year return is. Further, small caps offer a unique opportunity since they have the most room to grow. Think about it, even large growth plays such as Apple (NASDAQ: AAPL) were once small cap stocks.

Don’t Forget

The fundamentals of investing still apply: you must be diversified. Investing in a small number of stocks (of whatever size) is assuming a level of risk that I am not comfortable with. If one stock heads for bankruptcy you could easily lose most of your portfolio (and never get it back). That’s right, never. So, stay diversified, monitor the fundamentals, and stay focused on the long view.

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With investors and the media focusing so much on near term stock market conditions (especially with another Fed rate announcement due out today), I thought now would be a good time to take a step back and look at a longer term, big picture view of the market. So, I started slicing up stock data - starting with market cap.

Small Caps - Risk vs. Reward

What peaks my interest is the performance of small cap stocks over time. I had always assumed that investing in smaller stocks was too risky. However, while these stocks do carry higher volatility and higher risk (as measured by the standard deviation of returns) the trade-off may be worth it depending on a person’s risk profile. Why? Have a look at the chart at left (click to enlarge it). Over the last 5 years, small cap stocks as measured by the Russell 2000 index (RUT) have outperformed the broader market (RUA) by an annualized 2.5 percentage points per year (that’s significant!). So, is the risk / reward worth it? I’ll keep you posted - I want to make sure that I consider all of the facts first and share them with you - especially the risk metrics.

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It’s no surprise that small cap stocks hold the potential for significant returns. However, high potential upside often comes with high risk and price variability, making thoroughly vetting small cap investments essential. That’s what makes Quality Systems, a California based developer of medical information and automation systems attractive (and a top Forbes small cap pick).

Quality Systems (QSII) - The Upside

At first glance, the value proposition makes sense: health care will continue to grow as aging boomers increasingly require additional medical services and products. The key to streamlining this process is leveraging IT to provide and track critical patient information. The company’s NextGen division, which accounts for almost 90% of revenues, has garnered several awards for its Electronic Medical Records (EMR) and Enterprise Practice Management (EPM) systems. These systems allow health care providers to efficiently manage back-office patient, financial, and administrative data. In addition, Forbes ranked the company as the #5 best small company, while Business Week named QSII #19 out of 100 top growth companies.

A quick look at key stock metrics reveals effective management: Trailing Twelve Month (TTM) Return on Assets (22%), Return on Equity (36%) and ROIC (35%) are all well above its peers in the software industry. In addition, a strong Operating Margin (31%), EBITDA margin (35%), and Profit Margin (21%) suggest a well managed and profitable enterprise. Finally, Quality’s management of debt and liabilities appears stellar, as it carries 0 debt (that’s right no debt) and a current ratio of 2.5X. The icing on the cake for stock investors is a dividend yield of almost 3% - much higher than its peers.

The Downside

On the downside, the company isn’t necessarily a deal with a Price / Earnings ratio of 30 (Most Recent Quarter) and a Price / Book ratio of almost 10. Similarly, a PEG of 1.01 suggests the company isn’t undervalued (but then again, it is a small cap growth company). Further, potential investors in this stock should be aware that an SEC investigation into trading practices of an executive on the management team is ongoing, though the company (after conducting an internal investigation) is confident no wrongdoing has occurred.

Conclusion

Despite having some concerns, we like the long term potential of this stock and the prospects for growth in the health care industry. As a result, we’ll add it to our small cap watch list.

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