Small cap stocks have been on a tear.
The Russell 2000 -- the index that small cap watchers rely on just like large cap investors look to the S&P 500 and the Dow Jones industrials -- provided investors with a total return of 38.8 percent last year. That topped total returns (price appreciation and dividends) of 32.4 percent for the S&P and 29.7 percent for the Dow.
One reason why small caps performed so well is because, unlike large cap stocks, they generally don't get a big chunk of their business from overseas where the economies weren't as strong last year as the U.S. economy.
"The U.S. economy performed better than most other areas of the world, which led to small caps performing better than large caps," said Dean Kartsonas, a managing director of Shorebridge Wealth Management, a Washington Landing investment manager.
Mr. Kartsonas said small caps have outperformed large caps over the last decade because they started the period priced at a discount to large caps in January 2004. They are now priced at a premium, which has prompted him and other investment managers to become more selective about small cap stocks.
There is no standard definition for how big a small cap stock can be.
While some limit the category to companies with market capitalizations -- the number of shares outstanding multiplied by the share price -- of $2 billion, others say companies can have market capitalizations of $2.5 billion, $3 billion or more and still be small caps, said Colin Symons, chief investment officer of Symons Capital Management in Mt. Lebanon. His firm's Symons Small Cap Fund [ticker: SSMIX] focuses on stocks with market caps of $200 million to $2 billion.
Western Pennsylvania stocks in the Russell 2000 include: Calgon Carbon [CCC], a Robinson environmental products and services provider; F.N.B. Corp. [FNB], Western Pennsylvania's third-largest bank; Koppers Holdings [KOP], whose products include chemicals, crossties for the rail industry, and poles for the utility industry; Cranberry-based safety products company MSA [MSA]; and Universal Stainless & Alloy Products [USAP], a specialty steel producer based in Bridgeville.
There's also a wide disparity in the performance of small caps.
Growth stocks in the Russell 2000 returned 43.3 percent in 2013 vs. a 34.5 percent return for value stocks, said Geoffrey Gerber of Twin Capital Management in McMurray. He said health care stocks in the index were the best performers, generating a 2013 return of 50.8 percent, while utilities stocks, with a return of 18.3 percent, were the worst.
The best performer in the Russell 2000 last year was Intercept Pharmaceuticals [ICPT], whose stock price jumped 809 percent. The New York company develops drugs to treat chronic liver diseases. GSE Holdings [GSE], a Houston company that makes liners used in energy, mining and other industries, was the worst performer. Its shares slid 88 percent.
Mr. Gerber said small caps are riskier and more volatile than their larger siblings. Some of that is because they do not garner as much attention from Wall Street analysts. So an investor who spots an encouraging development or a troubling trend with a small cap stock can get a jump on other investors.
That doesn't typically happen with large cap stocks. News about them is widely available and shared faster. Their stock prices quickly reflect that shared knowledge.
Because of their risk and volatility, small caps generally outperform large caps over the long term. Since 2004, the Russell 2000 has produced annualized returns of 9 percent, vs. 7.4 percent for the S&P 500 and the Dow. However, last year's run-up left small stocks looking expensive.
"It used to be you got a discount for buying small cap stocks. Now you're paying a premium," Mr. Symons said.
While it's true that small caps should still benefit from the relatively stronger U.S. economy, "How much extra do you want to pay for that?" he asked.
Twin Capital shifted its allocation more toward small caps at the beginning of last year, according to Mr. Gerber. But he noted that the price-earnings ratio of the Russell 2000 at the end of the year was 33.6, about 34 percent higher than its average over the last 35 years. The index's price-to-book ratio was 25 percent above its 35-year average, he said.
Although Mr. Gerber believes they will continue to outperform large caps, he thinks the performance of small caps will be more muted this year.
"I still like them. I just don't like them as much as I did last year," he said.
Mr. Kartsonas said he is also going to be more selective about small caps, despite the fact that they should continue benefiting from the strengthening U.S. economy.
"I think it's going to be tougher from this point to outperform large caps," he said.
Mr. Kartsonas said the role that small caps should play in an investor's portfolio depends on that individual's tolerance for risk.
Len Boselovic: email@example.com or 412-263-1941.