Two Myths of Small-Cap Investing Debunked!

Kurtis Hemmerling  |

Small-cap stocks have earned the reputation as the ‘wild card’ of the stock market game. But do these tiny firms deserve the notoriety and can investors mitigate the potential risks?

While definitions vary, a small-cap stock is often defined as having a market capitalization between $300 million and $2 billion. (Calculated as a function of outstanding shares multiplied by share price).

And there are other characteristics generally associated with these stocks as well. They include:

  •  Illiquid trading
  • Often opaque over-the-counter exchanges
  • Extreme price volatility

Small cap investors are often looking for the next Microsoft (MSFT) or Apple (AAPL) … before it takes off. They investigate a company’s story looking for the David that will take out Goliath for long-term upside gains of 10 or even 100 times their original investment.

But are small-caps simply a function of high-risk/high-reward? Or is there more to the story?

For instance … let’s examine the myth around volatility.

The “High-Risk” Myth of Volatility

First, all volatility is NOT equal. There’s a difference between a volatile stock that trades with leveraged moves up and down with the market as opposed to companies that greatly outperform the market while the market is advancing but exhibit price strength in a down market.

The technical terms to differentiate these two are Sharpe and Sortino ratios. A stock that rises 25 percent faster than the market … but only drops proportionate to its applicable benchmark is a LOWER risk investment despite the higher volatility. Why is that the case? Because your investment is leveraged for gains but not for losses resulting in higher reward for the same amount of risk.
But how do you achieve higher gain while limiting your loss? To answer that we need to examine another myth – market timing.

The “Market Timing” Myth of Small Cap Investing

Is market timing even possible? Most analysts would say no. They claim that statistical testing has not yet proven the ability to “time the market”. Why would an investor attempt a technique that is not yet proven? Then answer lies with how statistical tests are carried out.

You see … standard Student t-statistics require market timing models to produce returns three times higher than a buy and hold method. Yet, market timing is not synonymous with market outperformance. Market timing is more closely linked to risk reduction or conserving capital during bear markets.

By this I mean you will achieve identical gains with market timing in a bull market, but you will reduce your holdings when a bear market is more likely the trend. Producing returns three times greater than a buy and hold method is unlikely. Yet, would it be wise to turn down a system that reduced risk and doubled your returns even if it didn’t satisfy the traditional Student t-statistic?

There are a variety of market timing approaches that include analyzing company earnings, price trends, fundamental valuations, institutional activity, sentiment indicators and more. By applying a market timing filter to your small-cap strategy you will be investing when the upside is more likely, thus making the volatility work for you instead of against you. And you will be sitting on cash when a downside is most probable – thus lowering your downside risk.

The market timing model I use analyzes broad market earnings trends in conjunction with a secondary confirmation signal on the S&P 500 price chart. When enough companies slash forward earnings estimates for an extended period of time, this signals a soft market and a price drop is likely. I confirm this with a moving average price trigger. This simple approach would have boosted gains in the S&P 500 over the last 11 years from 20 percent to 262 percent total return.

What sort of gains are theoretically possible when you manage for the various risk factors in small-caps through strategic investing practices?

Sub-$15 Small-Cap System

(Click to enlarge)

My sub-$15 small-cap system targets liquid stocks on major exchanges that are of high quality with decent price performance. It includes market timing and monthly rebalancing of an optimum 15 stocks. You can read more about this exclusive model at Portfolio Café.

How well has this strategy performed historically? This back-tested strategy generates a theoretical return of 17,656 percent in 11 years while the broad market has risen 21 percent during the same time frame. This translates into a compound annual growth rate of over 60 percent.

What sorts of stocks are singled out for accumulation? Last month (February to March 2012) the strategy picked up 15 companies that included ChipMOs (IMOS) with a 60-percent profit, Heska Corporation (HSKA) with a 31-percent gain, CYANOTECH CORP (CYAN) with a 27-percent rise and ClickSoftware Technologies (CKSW) with a 24-percent jump. The biggest loser was Richmont Mines Inc. (RIC) with a loss of less than 22.56 percent. The 4-week return was 7.81 percent, which beat the market by 5.48 percent.

The New Small-Cap Investor

Sophisticated screening software, discount basket trading, and clever strategy are tools of the new small-cap investor. Instead of looking at small-cap stocks as a long-term speculation where you hope to find the next Facebook (FB), consider buying baskets of small quality firms with methodical rebalancing when the market is not in a downtrend. The rules are slowly changing in the markets where strategy is trumping story and the excess gains of small-cap stocks are on the table for the taking.

Stock price data is provided by IEX Cloud on a 15-minute delayed basis. Chart price data is provided by TradingView on a 15-minute delayed basis.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not necessarily represent the views of Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to:

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