While the broader market has been choppy in the last year or so, small cap stocks have significantly outperformed the major blue chip indexes. The Russell 2000, the most common grouping of small cap equities, has returned +19% in the last 12 months – nearly double the +10% generated by the S&P 500 large cap index. Most recently as the market has rebounded since September 1, the Russell 2000 index has added +17% in a little under two months while the S&P has tacked on about +12%.
So what’s the appeal of small cap stocks — stocks like ARM Holdings (NASDAQ: ARMH)? Perhaps the largest selling point is that these are companies with much more growth potential than established blue chips. It’s infinitely simpler for a restaurant with just a few stores to grow its sales or revenue at an impressive 50% or 100% rate per quarter through rapid expansion – as opposed to a giant like McDonald’s (NYSE: MCD) that has very little room to grow. One report says the absolute farthest distance you can be from a McDonald’s location in America is just 115 miles!
Besides, even if MCD wanted to become even more ubiquitous, Wall Street is littered with the wreckage of companies that grew too widely and too quickly. Starbucks (NASDAQ: SBUX) and Krispy Kreme (NYSE: KKD) immediately spring to mind.
Clearly, small cap stocks are more nimble and able to tackle the market trends of the day more efficiently than big bureaucratic blue chips. They also have greater growth potential. But the catch is knowing when that exponential growth potential is starting to fade – or to put it another way, when a small company can no longer be called “small.” That is not to say there is no longer the potential for bigger sales and profits, but just that those gains will be less dramatic.
To help you figure out the tipping point for the surging small-caps in your portfolio, here is an in-depth analysis of ARM Holdings (NASDAQ: ARMH), a former small cap stocks that could be slowing down now that it is becoming an established large cap tech stock:
ARM Holdings (ARMH)
Market cap at the end of fiscal 2007: $1.7 billion
Current market cap: $7.8 billion
ARM Holdings (NASDAQ: ARMH) is a U.K. tech company that designs and sells microprocessors — and most importantly, provides chips to electronics powerhouse Apple Inc. (NASDAQ: AAPL). Thanks to its partnership on the iPad, ARMH stock has exploded about +400% since early 2009. Revenue for the current fiscal year is expected to double — topping $600 million, compared with $305 million in fiscal 2009.
So can ARM Holdings keep it up? Well, in the short term things look rocky. ARMH stock has lagged the market considerably since Sept. 1, up just +2% compared to +12% for the S&P 500, thanks to total iPad sales for the quarter missing Wall Street estimates by a fairly large margin. To see revenues double again anytime soon, it’s going to take a surge in iPad sales or another massive contract akin to the iPad deal that can generate a few hundred million dollars in one fell swoop. Unless you think either of those events are likely, chances are you should give up hoping that the breakneck growth of ARMH will continue in the months ahead.
Keep in mind also, that Wall Street doesn’t see much future growth potential either – at least not for ARMH shares. The company has been downgraded 6 times since March of this year – and of the 3 analysts with firm price targets, all of them have forecasted a significant downside. Those targets are $8, $10 and $12 compared with a current share price of around $17.
Of course, if you set the ceiling at the level of current chipmaking heavyweights Intel (NASDAQ: INTC) with annual sales of about $44 billion and Advanced Micro Devices (NYSE: AMD) with annual sales of about $6.5 billion, ARMH has a lot of room to grow. But unseating those established industry leaders will be no small task and likely will not occur overnight. That means hopes of another double in stock price or annual revenue is probably not likely, and ARM Holding’s rapid growth will return to reasonable levels soon – if it has not already.
Jeff Reeves is editor of InvestorPlace.com. As of this writing, he did not own a position in any of the stocks named here. Follow him on Twitter at http://twitter.com/JeffReevesIP.
