Are You Researching the Wrong Stocks?

David versus Goliath — it’s a classic script you know well.

A smaller player rises up against the odds to beat a larger rival.

We often link David versus Goliath encounters to the sporting field. At other times the battle may pit an individual against a big corporation.

But is this sort of match-up relevant to stocks?

Well, I think it is.

History shows that smaller stocks often outgun their bigger cousins. And this has important implications for you. It could change the way you structure your portfolio.

Let me tell you what I mean…

Most of my trading is algorithmic these days. But I still follow a handful of analysts. This helps me develop a broad market perspective. It’s also the source of some unique research.

One of my favourites is Rod Smith — the chief strategist at RiverFront Investment Group. He publishes a commentary called The Weekly View. It’s free, and well worth a look.

Last week’s edition had some fascinating research. The focus was on the performance of small-cap stocks versus large ones. And sure enough, it’s the small-cap stocks that come out on top.

Have a look at this chart…

Source: RiverFront Investment Group
Click to enlarge

The graph shows the performance of US small-caps after inflation. It goes back to 1926 and includes thousands of stocks. RiverFront estimates the trend averages 8.2% per annum.

So how about the Goliaths?

Well, their average return is around 6.4% — nearly 2% lower. This performance margin makes a huge difference over time. Small-caps are currently ahead by a staggering 400%.

No one can say if these trends will persist. The future could bring different rates of return. But I have no reason to believe that small-caps will lose their dominance.

Your edge in the market

Many retail traders see themselves at a disadvantage. They believe the big investment firms have more resources and better information. The little guy — they think — is always a step behind.

But this is wrong.

You actually have an important edge over the big firms. This is because you have less capital to invest. In turn, this makes it easier to take advantage of small-cap opportunities.

You see, a big fund can have difficulty trading smaller stocks. There simply isn’t always enough liquidity. This often results in a reliance on larger companies in the ASX 200.

There are over 2,000 listings on the local market. Of these, you’ll only find a small portion in the big indices. This opens a lot of possibility for the retail trader who knows where to look.

Quant Trader doesn’t signal the biggest ASX stocks (typically those in the top 40). This makes more room in the portfolio for small to mid-cap companies.

Now, don’t get me wrong. There’s nothing wrong with a blue-chip portfolio. But, like you saw earlier, you can make more money outside the majors.

And this makes sense.

Emerging companies naturally have strong growth potential. That’s what often drives the share price. It can also lead to takeover activity, which produces further share price gains.

Ask yourself this: Which stock is more likely to double in the next two years — a company in the ASX 50 or a rapidly growing small to medium size business?

The answer is obvious. You can see why smaller stocks have historically done well.

Future household names

A member made a suggestion a while back. His view was that Quant Trader should just track the ASX 200. He didn’t think it was worth bothering with stocks that no one knows about.

Well, Quant Trader does bother. It looks beyond the top 200. The system scans hundreds of essentially anonymous businesses. This is where you’ll find many of the best opportunities.

I had a look at Quant Trader’s portfolio during the week. The aim was to see if live signals were uncovering smaller companies that are getting bigger. The findings were interesting.

At the top of the list was mobile phone business Vita Group [ASX:VTG]. It demonstrates the growth potential of smaller stocks perfectly. It began with one store in 1995, and now operates over 100.

Quant Trader’s first signal was in December 2014. The shares were up over 260% in last week’s update (25/8/16). The second and third signals are also showing triple-figure gains.

So how big is VTG?

Quant Trader uses a custom algorithm to rank stocks. It gives a similar result to ranking by market capitalisation. This allows the system to order stocks from largest to smallest.

VTG’s rank was 455 at the time of the buy signal. The company wasn’t big enough to make the ASX 300. But don’t think this is a micro stock. VTG has a market cap of over $700 million.

The second best performing stock is Smartgroup [ASX:SIQ] — a salary packing business. The shares were up by 180% at close of business yesterday.

SIQ is a little larger than Vita Group. Its ranking at the time of the first buy signal was 283. The big funds that focus on the ASX 200 will NOT have this stock in their portfolios.

In third position is a larger company — Aristocrat Leisure [ASX:ALL]. This stock’s ranking was 71 when Quant Trader gave its first buy signal. ALL is one of the largest stocks in the portfolio.

Here’s a table showing Quant Trader’s top 10 open trades…

Company Code Rank Gain
Vita Group VTG 455 263.3%
Smartgroup SIQ 283 185.4%
Aristocrat Leisure ALL 71 129.1%
SG Fleet Group SGF 309 106.7%
Webjet WEB 233 95.3%
Fisher & Paykel FPH 277 84.8%
Auckland Airport AIA 302 84.7%
Sealink Travel SLK 518 82.8%
Catapult Group CAT 431 80.9%
Dacian Gold DCN 321 67.3%

I wouldn’t call any of these stocks household names. A couple of them may have a familiar ring. But none make it into the ASX 50. Aristocrat is the only company to come close.

Have a look at each stock’s rank. The average at the time of the first signal was 320. Many of them were not in the ASX 300. In fact, Catapult Group was (and still is) outside the All Ordinaries.

Now, let me stress this next point. None of these stocks are micro businesses. They all have market caps in the hundreds of millions of dollars. But they are small in comparison to the leaders.

Smaller stocks won’t always do well. That’s why I always tell people to spread their risk. It’s also important to have an exit point. This gets you out when a situation changes.

But I think it’s interesting. You can do very well in stocks without buying a single Goliath.

Until next week,

Editor’s Note: Does your portfolio have many emerging stars?

Don’t worry if the answer is no. The ASX has over 2,000 listing. I can understand why many traders don’t get past the top 100 or so stocks. But here’s something you should do…

Check out Jason McIntosh’s Quant Trader advisory service. It’s a fully algorithmic trading system for ASX stocks. Quant Trader scans practically every company. I can just about guarantee you’ve never heard of many of these unique ideas.

If you’re not familiar with Jason, he was a trader at one of the world’s most powerful investment banks for nearly a decade. His experience is hard coded into Quant Trader’s algorithms. And the results speak for themselves.

So if you’d like help finding the emerging stars…I strongly suggest you look into Quant Trader now.

Try it. See if it makes sense to you. It could change the way you trade forever.

You can also read about a very special limited time offer! It’s only available midnight Monday. This is your chance to get Quant Trader for an unbelievable price.

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.

Money Morning Australia is published by Fat Tail Investment Research, an independent financial publisher based in Melbourne, Australia. As an Australian financial services license holder we are subject to the regulations and laws of Corporations Act and Financial Services Act.

Money Morning Australia