Do you want to invest in the stock market but fear you have missed all the good opportunities? There are two choices that I currently see that make sense to a degree. I will take a look at one of these two choices in this post and will consider the other for a future post. The asset class that we will examine at a later date are the emerging markets. This market has been relatively flat for the last few years and may be poised to remain that way as interest rates begin to rise as economic conditions improve. Of cource raising rate will have an effect of the second as well, but we will come to that a little later, the second asset class is small capitization stocks in the US. With the S&P 500 and DOW reaching new highs in recent months, small caps are an investing opportunity. It is no wonder people are hesitant to buy right now as that would fall into the buying high which is not the best way to make money in the markets.
As I just alluded to you do not want to be in the buying high category of investing so lets look at why small caps are attractive right now. Small caps, thus far, in 2014 have been relatively flat and have not participated in the massive stock runs that large cap and blue chip companies have experienced. And the best part of this asset class is that historically since 1926 small cap companies have beaten the larger capitalized companies. While, just like large cap stocks, small caps have experienced bull and bear periods and have averaged two percent points more than large cap stocks over the long run. While I do not recommend a buy and hold strategy, the exception could be a good small cap mutual fund or exchange traded fund.
So why do small caps on average have a higher return than large caps? The simple reason is there is more risk in buying and owning a small cap so therefore they should have a higher return. How much riskier as small caps than their larger counterpart? Over the last ten years the index that tracks small cap stocks, the Russell 2000, has been over 30% more volatile than the S&P 500. But as I told you earlier that these stocks are the exception to not buying and holding. Being volatile is not a primary concern over the short term as these are indeed long term investments. Do not let the ups and downs bother you and remember that you are a long term investor when it comes to small cap stocks.
While there is plenty of information and analysts to follow if you are going to own a large cap, the reverse is the case for small caps. Most small caps have very few analysts that follow them, and thus that creates a lack of exposure on these diamonds in the rough. In a prefect world, a stocks price is based on all known data which is to create a fair and equitable price for that stock. Well, small cap stocks do not have that exposure and thereby lack the amount of public knwoledge that large cap followers enjoy. But any piece of news that comes out about a small cap could cause significant shifts in prices that could go either up or down depending on the news. With a small cap if a large investor or any institution buys or sells in a large quantity it is going to have a significant impact on the price of the stock. But then again, remember with small caps we are ignoring the volatility and in these picks for the long haul.
Along with the volatility that small caps experience, interest rates have a bigger impact on these companies than they do on large caps. Smaller companies have a more difficult time in accessing money to fund expansion and growth when rates are higher because it will cost them more to fund this expansion.
But do not over think the current likes and dislikes of the markets or to time them. Know that under certain circumstances, different sectors react differently which can create buying opportunities even when we have markets like we do know that are setting all time highs. Now to define a small cap stock. A small cap stock is one whose market capitalization is under $5 billion. And the lower the capitalization, the more profits you can expect to make provided the company is fundamentally sound. The reason for this is there is more room for movement towards the upside price wise and more room for the company to grow. Of course, this greater potential for rewards does not come without greater risks so keep that in mind when you purchase a small cap.
But I do not recommend buying individual small cap stocks unless you have the time to do your research and follow the company as an analyst would as any small negative comment could destroy any potential gains. So I advise buying small caps in either a mutual fund or an exchange traded fund. The key here is to find a fund that invests in small caps in the market capitalization that you are seeking. Keep an eye on expense ratios to keep more of the gains in your investment and out of the hands of the fund managers. But unlike large cap funds, be prepared to pay for the expertise of a fund manager and in these instances I do think that provided the fund does better than the averages, a good fund manager is worth the fees they charge. Otherwise, look at buying an exchange traded fund with similar characteristics of a mutual fund you like at a lower cost.
If you have any questions or need any more information on small caps, please feel free to contact me.
