Small-Cap Stocks – A Thrilling Risk

‘We estimate that an area of just one square kilometer [0.39 square mile], surrounding one of the sampling sites, could provide one-fifth of the current annual world consumption of these elements.’ – Yasuhiro Kato, Tokyo University, The Wall Street Journal

We’ll come back to this quote in a moment.

But first…

Today, We’ll talk to you about risk and return.

If you want to be successful in this game and make a lot of money, it’s important you understand it. But it’s also important you understand what effects risk and return.

The payoff for taking a bigger risk is the chance for a greater reward. For adrenaline junkies, chess is a low-risk activity. It won’t get their blood pumping, but they’re also not likely to get injured.

On the other hand, sky diving is high risk. Jumping from a plane at 15,000 feet is sure to set anyone’s pulse going. But the flipside of the thrill is, when compared to chess, there’s a higher risk of an accident.

But some people take the risk because they enjoy the reward – the thrill…the rush.

Investing is similar. Stick your cash in the bank and you’ll get a nice 5-6% return. But you won’t get much – if any – excitement.

Small-Caps Stocks – High Risk, High Reward

The opposite of cash investing is small-cap stock investing. You can rack up gains of 50%, 100% or even 300% in a matter of months. That’s the reward. The risk is the price can zip all over the place – up 10% one day, down 5% another.

If you can handle that kind of action, then small-cap investing is for you.

But what’s that got to do with the quote at the top of this letter?

It’s an example of how the risk and reward for a stock can change overnight.

Take last year’s Japanese discovery of a new deposit of rare earths as an example. It could provide up to one-fifth of the current annual demand. There’s only one problem. The deposit is four kilometres below the Pacific ocean surface.

Last year, rare earths stocks were all the rage. We tipped a couple and investors made good returns. But when our trailing stop order was triggered, we sold out for gains of 192% and 130%.

But big price moves can have an interesting impact on investors. For instance, we tipped Lynas Corp [ASX: LYC] at 50 cents. We sold at $1.46.

Now, if an investor has a price target of $3 on the stock, buying at 50 cents is a great punt. The downside is only 50 cents per share…whereas the upside is $2.50 per share. In other words, the risk reward ratio is 1:5.

But if you buy at $1.46 and the price target is still $3 the risk reward is 1:1. You’re risking $1.50 to make $1.50. Don’t get us wrong, for some stocks that’s fine.

But for a high-risk play like rare earths, betting $1.50 to double your money isn’t great odds.

For the past three years or more, rare earths prices and stocks have traded on the basis of limited supply and China’s near-monopoly on the industry.

But then, out of nowhere a report reveals the discovery of a deep-sea rare earths deposit. So now investors think, “What will that do to the supply, demand and price of rare earths?”

Suddenly the idea of a Chinese stranglehold and ever-increasing rare earths prices doesn’t look so strong.

For prices to go higher the news has to be better and better each time. But with few exceptions, that’s not possible.

Buy Small-Cap Stocks Early

Buying small-cap growth stocks means getting in before other investors know about them.

While this is a high-risk strategy, in one way it’s less risky than buying late. Simply because by the time most investors find out about it, they’re buying into a rising stock and all the known good news is built into the stock price.

But once the momentum stops, it can be tough to get going again: the stock isn’t cheap anymore, so it’s less attractive to small-cap punters, and the momentum has gone so it’s not attractive to momentum investors.

The end result is the stock gets stuck in a trading range, waiting for more news to push the stock out of it.

That’s where rare earths stocks are now.

Right now, at current stock prices investors have seen it all before. It’s just not enough to convince new investors to pay these prices.

Of course, this isn’t unique to rare earths. We’re just using it as an example.

But eventually stock prices fall to a level where they are worth buying.

We’re now ready to take a punt on some beaten-down stocks…stocks we believe are trading at fair price, and where the risk/reward could see you make big triple-digit percentage gains, rather than small double-digit gains.

Kris Sayce
Editor, Australian Small-Cap Investigator

Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

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