Few stories capture the imagination so well…
A smaller player overcomes the odds to beat a larger rival.
You’ll probably recognise the storyline instantly — David and Goliath. This epic battle between the shepherd and a nine-foot warrior has become folklore.
We often relate David and Goliath struggles to the sporting field. At other times, the tussle 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 explain what I mean…
These days, most of my trading is algorithmic. But I still follow a handful of analysts. This helps me form a broad market perspective. It’s also the source of some unique research.
One of my favourites is Rod Smyth — the chief strategist at RiverFront Investment Group. He publishes a commentary called The Weekly View. It’s free, and well worth a look.
I was looking over a recent edition of Smyth’s research during the week. It had some fascinating charts showing the performance of small-cap stocks versus large ones.
And sure enough, it was the small-caps that came out on top.
Check this out…
Total Real Return of US Small-Caps
Source: RiverFront Investment Group
This graph shows the total return 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%. The performance gap of nearly 2% has a huge impact over time. Small-caps are currently ahead by around 400%.
No one can say if these growth rates will persist — the future could be different.
But I believe small-caps will continue to hold the upper hand.
Your edge on the pros
Many retail traders claim to be at a disadvantage. They say the big investment firms have more resources and better information. In their eyes, retail traders are always a step behind.
But this overlooks a key fact: liquidity.
You see, fund managers often have trouble trading smaller companies. There simply may not be enough stock available for them to buy a meaningful stake.
Another issue funds face is their investment mandate. In many cases, smaller stocks are not an option. This often results in a reliance on larger companies in the ASX 200.
Retail traders typically don’t have these issues. Their smaller trade size gives them the ability to target just about any opportunity. This gives them an edge on the pros.
The ASX has over 2,000 listings. Of these, only a small portion go into the main indices. This opens a lot of possibilities for the retail trader who knows where to look.
Now, don’t get me wrong — there’s nothing wrong with buying the big blue-chip names.
But like you saw earlier, you could make more money outside the majors.
And this makes sense…
Emerging companies naturally have strong growth potential — this is often what drives the share price. Takeover activity could potentially produce even more upside.
Ask yourself this: Which stock is more likely to double in the next two years? A big household name business or a rapidly growing small to medium size company?
The answer is obvious. You can see why smaller stocks have historically done well.
Beyond big names
So should you look outside the ASX 200?
Well, it’s interesting.
S&P Dow Jones Indices (S&P) manages the ASX index series. They rebalance the indices each quarter — removing stocks that no longer meet the criteria and adding those that do.
Inclusion in the ASX 200 is a big deal for a company. You see, it clears the way for many of the big funds to invest. This opens the door to more investment dollars.
S&P recently released its latest re-balance. And it made for some interesting reading…
Four stocks made their way into the ASX 200:
- Ausdrill Ltd [ASX:ASL],
- Bellamy’s Australia Ltd [ASX:BAL],
- Smartgroup Corporation Ltd [ASX:SIQ]
- Xero Ltd [ASX:XRO]
This is the green light for many of the big funds.
But if you’re a private trader, the time to buy was months ago.
You see, all four stocks are in Quant Trader’s portfolio. Each of them began large upward trends long before they met the criteria for the ASX 200.
The key was to spot the trends early. It was then a case of exploiting your edge over the pros.
Let me show you the difference this could have made…
First is Ausdrill — a mining services company that operates in Australia and Africa.
Here’s the chart:
Source: Quant Trader
You’ll see two key points: First is Quant Trader’s buy signal on 17 February 2017. The other is 9 March 2018 — the day of S&P’s announcement that ASL was entering the ASX 200.
Quant Trader’s entry was over a year before ASL’s ASX 200 inclusion. Looking at it another way, the $1.52 entry price is a 44% discount to the price fund managers were potentially paying.
The next stock is infant product producer Bellamy’s.
Source: Quant Trader
Just like Ausdrill, Bellamy’s was on the rise long before its ASX 200 inclusion. It’s this sort of growth that pushes a stock into the top 200 companies.
But for many fund managers, Bellamy’s relatively small size may have been a problem.
This is where everyday traders like you have an advantage. Your smaller trading size, and greater flexibility, opens opportunities many of the funds miss.
Quant Trader’s entry was at $7.85 in August last year. The stock’s closing price on 9 March 2018 was $20.45 — a late entry premium of 160% for ASX 200 watchers.
Next up is salary packaging business Smartgroup.
Source: Quant Trader
It’s a familiar story…
An emerging company makes big gains ahead of ASX 200 inclusion. In this instance, the early buy signal is at a 38% discount to the price on 9 March 2018.
The final stock is Xero.
Don’t worry if you haven’t heard of it. You wouldn’t be the only one. A lot of the Overflow’s small-to-mid-tier companies are a mystery to most traders.
Check this out:
Source: Quant Trader
XRO produces cloud-based accounting software for small-to-medium-size businesses. Its recent inclusion in the ASX 200 will likely boost the company’s profile.
But the advantage goes to the early movers. Traders with an eye for smaller companies have already made big gains. XRO’s price on 9 March was 86% above Quant Trader’s entry signal.
Smaller stocks won’t always do this well. Some will flounder and never make it to the big league of ASX companies. That’s why I always tell people to spread their risk.
It’s also important to have an exit stop for when things change. Many traders waste years clinging to the hope that a small stock will soar. You need to know when to walk away.
But the potential benefit of smaller companies is undeniable.
You could do very well in stocks without buying a single Goliath.
Until next week,
Editor, Quant Trader
Editor’s note: There are countless examples of up-and-coming stocks beating the majors. But sadly, many traders only hear about them after the battle is won.
But that doesn’t have to be you…
Jason McIntosh’s Quant Trader is a fully algorithmic trading system. And it has a proven ability to detect big trends in ASX stocks early.