The Big Reason Small-Caps Can Outshine Blue Chips

Small cap stocks can generate greater profits than blue chip stocks

Welcome back to your Extreme Small-Cap Profits email course.

We’re now on Day 9 of 12.

If you missed yesterday’s email, I talked about when you should sell your small-cap investments.

Investors generally like to focus on buying. They want to buy the right stock at the right price. But once they’ve bought, they think the job is over.

Knowing when to sell is just as important as knowing what to buy. If you sell too early, or at the wrong time, you could seriously limit your potential gains.

You might even increase your losses selling when you shouldn’t.

Today we’re going to take a step back and look at how the economy affects small-caps stocks.

But first, let me explain how the economy works.

It’s probably a lot simpler than you think.

The economic machine

The economy isn’t hard to understand.

As long as you can understand transactions, you can understand the economy.

A transaction is when money is traded for goods, services or financial assets.

A group of similar transactions makes up a market.

There’s markets for a whole bunch of goods, services and financial assets. For example, there’s a market for orange juice, cleaning services, and stocks.

The economy is simply all these markets added up.

When the economy is doing well, spending and output (goods and services) increases.

And because someone’s spending is somebody else’s income, it encourages more spending and more output.

Higher incomes also help people and businesses to borrow more money. Banks are happy to oblige because incomes are rising.

And because banks are willing to lend, spending and investing picks up.

So how does this affect small-cap stocks?

As the economy grows, output increases, increasing corporate earnings. This prompts investors venture into the market and buy highly profitable stocks.

Of course, the opposite happens when the economy slows down — production growth slows, and so too does earnings.

Thus, investors like jumping into stocks when earnings growth is high and the economy is chugging along.

There are disruptions in the economy of course. The biggest is central banks.

With the power to change interest rates, they can affect demand for credit and stocks. But that’s another subject entirely.

Let’s now take a look at how small-caps perform in a growing and slowing economy. 

Great in booms not so much in busts

As I mentioned in Day 2, small-caps are extremely volatile. Because orders to buy and sell are so few, prices can more easily move.

This is a real benefit when the economy is doing well.

When businesses are producing more and earnings are increasing, investors flood into the market. And because there are few sellers, the flood of buyers pushes prices up far higher.

This happened in the 1990s. Our economy was growing above 4% multiple times throughout the decade.

Investors flood into the stock market. The All Ordinaries rocketed up more than 100% over that time.

Money Morning 25-04-18

Source: Bloomberg

[Click to open new window]

But in a far shorter span, small-caps like Prime Media Group [ASX:PRT], Energy World Corp [ASX:EWC] and Resolute Mining [ASX:RSG] rocketed up far higher.

Money Morning 25-04-18

Source: Bloomberg

[Click to open new window]

Of course, the opposite can happen when the economy slows down. When we slowed down in 2007–09, small stocks were hit hard.

Not only were investors selling to protect what capital they had left. The economic down turn hurt small-cap profits, thus prompting even more investors to sell.

Take a look at the Small Ordinaries compared to the All Ordinaries over that time:

INDEX ASX: XAO 25-04-18

Source: Google Finance

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The Small Ordinaries (XSO) fell more than 10% past the All Ordinaries (XAO) in early 2009.

The aim here isn’t to try and time your investments. I believe small-cap investing could be profitable whether the economy is doing well or poor.

Instead, you should be aware of how these external factors might affect your investing.

Interest rates, economic down turns and the supply of credit can all affect small-cap stocks in the short-term.

But long-term, what impacts small-caps far more is their earnings potential.

Small-caps perform regardless

Small-caps can outperform overtime, regardless of what the economy does. Small-cap analyst veteran, Greg Dean agrees.

He believes that because small-caps tend to control their own fortunes, they’re more resilient to economic events.

Typically, it’s not so much that they do well in great times, but those businesses that are in control of their destinies suffer less in bad times,’ Dean said.

There are a few reasons for that. Because they operate in industries with less regulation, they are less susceptible to things like interest-rate pressures or political intervention. Call them left-field risks that can come out of nowhere.

It’s just another reason to put your money in small-caps.

That’s it for Day 9.

Tomorrow we’re going to put everything together.

Stay tuned.

Cheers,

Härje Ronngard,
Editor, Money Morning

 

Harje Ronngard

Harje Ronngard

With an academic background in finance and investments, Harje knows how simple, yet difficult investing can be. He has worked with a range of assets classes, from futures to equities. But he’s found his niche in equity valuation.

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