Why Small-Cap Stocks Could Be Your Best Investment in 2013

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Is it a bad time to buy stocks?

Our answer may surprise you. Bizarrely, although it could be bad news for stocks in general, it won’t be bad news for all stocks.

The next twelve months will continue the trend from the last twelve months. It will continue to be a stock-pickers market. But rather than investors picking blue-chips for yield, the action will come in the small-cap sector.

The Split in Australian Stocks

Yesterday we showed you the chart of the Emerging Companies Index against the financial stocks index. Here it is again:

Emerging Companies Index Against the Financial Stocks Index

Source: CMC Markets Stockbroking


Over the past six months dividend-paying financial stocks have taken off in anticipation of falling interest rates. At the same time investors ditched small-cap stocks and most other growth stocks.

But now that investors have got their yield play, what’s next?

Interest rates are low, and they’ll stay low for the foreseeable future. The knock on effect is lower dividend yields.

Most investors don’t realise that. Most investors look back to the 6%, 7% and 8% dividend yields of the 2000’s and think those days are still here.

They’re not. Just as the days of high-interest bank accounts are over (for the foreseeable future) so are the days of high dividend yields.

Why is that?

It’s a simple fact of investing that all investments trade relative to other investments. Put simply, if one income producing investment is riskier than another income producing investment, then the riskier investment should provide a higher income.

The higher income is your reward for taking on more risk.

But dividend yields aren’t static. They change as the market changes. So when bank deposit rates fall, investors look for higher returns elsewhere. This can result in investors buying shares, which pushes up the share price and therefore lowers the dividend yield.

You’ve seen that same scenario play out in the bond market as investors looked for the safety of bonds, which drove up bond prices and drove down bond yields (bond prices move inversely to bond yields).

We believe things are about to change. As dividend yields reach their new ‘norm’ investors will start looking at growth assets. And one of the biggest beneficiaries of this change looks set to be the biggest growth assets – small-caps.

Why Small-Cap Stocks Will Rise in 2013

But here’s the thing, large-cap stocks and small-cap stocks have reacted differently on the Aussie market than on the US market.

Look at the above chart again. There’s a 30 percentage point difference between large and small-cap stocks over the past year. Now look at the relationship between large and small-cap stocks in the US over the same period.

Below is a chart of the US Dow Jones Industrial Average (blue line), and Dow Jones US Small-Cap Index (red line):

a chart of the US Dow Jones Industrial Average and Dow Jones US Small-Cap Index
Click here to enlarge

Source: Google Finance

Of course there are a whole bunch of reasons why Aussie small-caps haven’t done as well as US small-caps.

The strong Australian dollar doesn’t help small-cap exporters, and because most resources are priced in US dollars it means fewer Aussie dollars when companies repatriate revenues and profits.

Another reason is that Aussie interest rates stayed higher than interest rates elsewhere in the world. Australia is also more affected by what happens in China…and for most of this year the Chinese economy has been on the ropes.

All of that has contributed to investors skipping growth stocks and heading into safer dividend stocks.

But despite these factors, companies tend to adapt. That’s the nature of capitalism. Companies that can’t adapt soon fail. Companies that can adapt replace them.

And because investors have ditched growth assets so savagely, it has created a sea of beaten-down, under-valued, and risky stocks.

It’s our bet that as investors look to boost their returns this is the end of the market they’ll look at. In anticipation of this, we have more open positions on the Australian Small-Cap Investigator buy list than at any point over the past two years.

And it’s not just the typical stocks you’d expect to find in a small-cap portfolio. Yes, there are resources stocks, but less than half of them are in energy or raw materials.

The others are in property, finance, media and technology. Some pay dividends, some are growth, and a couple of them offer a mixture.

Right now we believe small-caps have hit rock-bottom, and that as we head into 2013 a combination of the fabled Santa Rally and investor recognition of extremely cheap valuations will see growth assets (especially small-cap growth assets) begin to recover.

As we always tell our small-cap subscribers, it’s not risk free, but if things go as we expect there could be some spectacular returns in the coming months.

Cheers,
Kris

From the Port Phillip Publishing Library

Special Report: The Fuse is Lit

Daily Reckoning:
Why the Australian Dollar is Not as Strong as You Think

Money Morning:
Central Bank Prints More Money – No One Cares

Pursuit of Happiness:
The One Industry Where the State and Government Excels

Australian Small-Cap Investigator:
Why Invest In Small-Cap Stocks? And Why Now?

Kris Sayce

Kris Sayce

Publisher and Investment Director at Money Morning Australia

Kris is never one to pull punches when discussing market developments and economic events that can affect your wealth. He’ll take anyone to task — banks, governments, big business — if he thinks they’re trying to pull a fast one with your money. Kris is also the editor of Tactical Wealth — where he reveals ‘special situations’ he’s discovered in the markets. If you’d like to more about Kris’ financial world view and investing philosophy then join him on Google+. It’s where he shares investment insight, commentary and ideas that he can’t always fit into his regular Money Morning essays.

Kris Sayce is the Publisher and Investment Director of Australia’s biggest circulation daily financial email, Money Morning Australia.

Kris is a fully accredited advisor in shares, options, warrants and foreign-exchange investments.

Kris has close to twenty years’ experience in analysing stocks. He began his career in the biggest wasp’s nest in the financial world — the city of London — as a finance broker back in 1995.

It’s there where he got his ‘baptism of fire’ into the financial markets, specialising in small-cap stock analysis on London’s Alternative Investment Market. This covered everything from Kazakhstani gold miners to toy train companies.

After moving to Australia, Kris spent several years at a leading Australian wealth-management company. However he began to realise the finance and brokerage industry was more interested in lining its own pockets with fat fees, commissions and perks —rather than genuinely helping out the private investors they were supposed to be ‘working’ for.

So in 2005 Kris started writing for Port Phillip Publishing — a company which was more attuned to his investment outlook.

Initially he began writing for the Daily Reckoning Australia— but eventually, took over Money Morning. It’s now read by over 55,000 subscribers each day.

Kris will take anyone to task — banks, governments, big business — if he thinks they’re trying to pull a fast one with your money! Whether you agree with him or not, you’ll find his common-sense, thought-provoking arguments well worth a read.

To have his investment insights delivered straight to your inbox each day, take out a free subscription to Money Morning here.

Kris is also the editor of Tactical Wealth — where he reveals ‘special situations’ he’s discovered in the markets that you could profit from. If you’d like to learn about the latest opportunity Kris has uncovered, take a 30-day trial of Tactical Wealth here.

 

Official websites and financial e-letters Kris writes for:

(You can find a list of recent investment articles written by Kris at the bottom of this page.)

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