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Are smaller stocks really the best way to earn outsized returns?

Credit: Tom Gores

Many Australian investors have been looking outside of the S&P/ASX 200 (INDEXASX: XJO) in recent years as favourites like Telstra Corporation Ltd (ASX: TLS) and BHP Billiton Limited (ASX: BHP) are perceived to have less potential for capital gains compared to up-and-comers.

However, a quick comparison of the ASX 200 index to the S&P/ASX SMALL ORDINARIES (INDEXASX: XSO) shows that taking a ‘kitchen sink’ approach to smaller stocks has not been a winning strategy.

Source: Google Finance

Source: Google Finance

(The ASX200 is the 200 largest companies in Australia by market cap, while the small ordinaries is numbers 200-300 by market cap)

The ASX200 has risen 8% in the past 10 years while the Small Ordinaries has declined 26% (both excluding dividends) in the same time. Also in a five year and a one-year time frame, the Small Ordinaries has consistently underperformed the ASX200.

This may seem counterintuitive, given that the top-10 biggest stocks in the Small Ords include Sirtex Medical Limited (ASX: SRX), Veda Group Ltd (ASX: VED), M2 Group Ltd (ASX: MTU), and BWP Trust (ASX: BWP), all of which have been fantastic outperformers.

However, the index also contains businesses like UGL Limited (ASX: UGL), Perpetual Limited (ASX: PPT), and Skilled Group Ltd. (ASX: SKE), all of which have heavily underperformed over the past ten years.

A key reason behind the index’s underperformance in recent years is likely to be the large number of mining and mining services stocks that were hammered, down and down, until they fell out of the index to be replaced with the likes of Catapult Group International Ltd (ASX: CAT), and Myob Group Limited (ASX: MYO).

Right now the list of companies in the Small Ordinaries reads like a list of winners, and I have a suspicion that the index could be a decent performer over the next five years or so. Alternatively, investors can reliably beat the index with a little careful stock-picking – which is where we come in!

Where to invest $1,000 right now

When investing expert Scott Phillips has a stock tip, it can pay to listen. After all, the flagship Motley Fool Share Advisor newsletter he has run for more than eight years has provided thousands of paying members with stock picks that have doubled, tripled or even more.*

Scott just revealed what he believes are the five best ASX stocks for investors to buy right now. These stocks are trading at dirt-cheap prices and Scott thinks they are great buys right now.

*Returns as of February 15th 2021

Motley Fool contributor Sean O'Neill has no position in any stocks mentioned. Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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