The Advantage of Going For Small-Cap Stocks

What is a stereotypical Wall Street trader to you? Warren Buffett probably doesn’t come to mind. I tend to think of Gordon Gekko, from the 1987 film Wall Street. While I know the majority of Wall Street traders aren’t like Gordon, he’s definitely my definition of the Hollywood interpretation.

He makes a boatload of money. He’s intelligent when it comes to managing capital. And of course, he has many flaws. In order to achieve his success, Gordon cheats, lies, and isn’t a novice when it comes to insider trading.

The movie paints Gordon as having an edge over everyone else. His edge comes from his psychology, capital and his lack of scruples.

Yet in reality, even large pools of capital are a perceived advantage rather than an actual advantage.  Does that mean investors like you and me have an advantage over hedge fund and mutual fund managers? I would argue yes.

Let me explain.

When trading large sizes, you need large amounts of liquidity in the stocks you’re looking at. If you’re going to buy $1 million worth of stock at $2 per share, there has to be an equal amount of sellers at $2 per share.

You can see how this limits big traders who are dropping huge orders into the market. The amount of liquidity they require is usually only found in the larger end of town — what you’ll hear called blue chips.

When it comes to microcaps, big traders can pretty much forget about it. In the Aussie market, microcap stocks usually have market capitalisations of less than $50 million.

As you can imagine, most large fund managers even have a hard time getting in and out of small-caps stocks — stocks with a market capitalisation less than $500 million.

Big traders just can’t drop piles of cash in the small end of town like they might want to.

Therefore these smaller stocks are usually reserved for retail investors, like you and me.

One of the advantages of being small is the amount of options it opens.

The advantage of choice

Most personal investors aren’t restricted by size. We can choose to invest in microcaps, small-caps, mid-caps and of course blue chips.

Having more choices makes it much easier for us to create wealth in the short term. Here’s an example to show you what I mean.

Let’s say the market isn’t doing so well. Not much of a stretch of the imagination there! And picking stocks among the largest in the market has become your worst nightmare. Every time you get into a blue chip stock it starts to slowly trade lower.

You might get a little bump here and there, but you end up chasing your losses. But why are blue chips falling in this scenario?

It’s simple: They have limited growth prospects in a pessimistic market.

The Australian Financial Review recently highlighted the poor performance of large-cap actively managed funds. The AFR stated;

Only 9.5 per cent of actively managed large-cap domestic equity funds beat the S&P 500 Index in the five years ended August 31. That’s the worst five-year performance since 1999, according to data from Morningstar.

Some blame the cheap money policies of central bankers for distorting fundamentals. Others note that markets seem to be driven by macro factors – the direction of rates, the rise and fall of energy prices, worries about global growth – rather than the earnings of individual companies.

But it can be boiled down even simpler. The market hates uncertainty. Right now no one knows what will happen. Will global markets get past their flat performance? Or are we in need of some radical changes to promote growth?

Who knows? But if there’s limited growth among the largest stocks, we can turn to small-cap and microcap stocks. Having the option to switch and go small is the biggest advantage we have as individual investors.

Of course, going small does mean you’ll be taking on more risk.

The risks of doing small business

It’s not uncommon for small-cap or microcap stocks to rise 100%, 500% or even 1,000% in a matter of months…or less. These kinds of returns are unheard of in the ASX200. But along with huge potential returns, comes increased risk.

I’ve already alluded to one of the biggest risks — liquidity risk. Therefore it might be harder for you to buy and sell at prices you want.

Another risk you should be aware of is volatility. Just looking at the returns of smaller stocks over almost any period will show that they are more volatile than large-cap stocks.

One day your position might be up 40%, but another day you might be down 20%.  When trading smaller stocks buyers and sellers have more influence on the price.  Not to mention the gross inefficiency in microcap and small-cap markets.

Therefore when you make losses, they’ll likely be larger than you’d normally expect. And the same goes for gains. Just make sure you have an exit plan. Let your winners run and cut your losers when they hit your predetermined stop losses.

Making huge returns when the market falls

Another advantage of smaller stocks is their ability to make huge returns even when the market falls.

Kris Sayce, Money Morning’s Publisher, demonstrates this point perfectly. In a Microcap Trader weekly briefing, Kris stated that the Brexit situations didn’t ‘mean a blooming thing’ to microcap stocks.

As microcap speculators, we’re interested in individual stock plays. We’re not interested in the macroeconomic picture.

We’re interested in entrepreneurs…we’re interested in ‘tiny stocks’ that have cracking and novel ideas…we’re interested in companies that could achieve huge growth, or pay a surprise dividend.

Most of all, we want to speculate on stocks priced in pennies today, which could be priced in dollars tomorrow.

The thing is, those opportunities are still here. And we’ll still look for and find them, regardless of whether the UK stays in or leaves the European Union.

At the time, the S&P/ASX 200 dropped 167.5 points, or 3.17%. Yet there were microcaps that rose more than 50% on the same day.

Source: Bloomberg
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Regardless of what you may hear, retail investors will always have some real advantages over big traders. We have more options and the ability to earn far higher returns, albeit by taking on some greater risks. Of course you shouldn’t invest all of your money into smaller stocks. How much you choose is up to you. But I wouldn’t recommend more than 10% of your investable funds.

Even if that’s only $1000, that’s fine. With the right stock selection you could potentially turn $1,000 into $10,000 in a matter of months. To find out how go here.


Härje Ronngard,
Contributing Editor, Money Morning

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