Small cap stocks have been described as the 'best profit opportunity of our lifetime', far out performing any other asset class by a huge margin.
But there is also a huge caveat here (Isn't there always?). All small caps are not alike.
While it is true that small cap stocks have outperformed their larger cap brethren to the upside (occasionally, even during bear markets) they have also outperformed to the downside. Even to the point of extinction!
Is there a way to increase the odds of success in taking advantage of the huge profit potential present in the small cap stocks arena? I believe that there is.
But first, let's define our terms:
Small cap stocks are defined as the smallest 30% of market capitalization stocks traded on the NYSE, AMEX and NASDAQ exchanges.
Small cap value stocks are defined as the top 30% of stocks with the highest book to price ratios (within the small cap grouping) traded on the NYSE, AMEX and NASDAQ exchanges.
Why are small companies able to grow faster than larger companies?
Witness the Law of Diminishing Returns at work! It is possible for an enterprise to reach a point that further capital investment yields less and less return on that investment.
Can you visualize a company the size of an Exxon Mobil (XOM), for instance, with its huge ($369 billion???) market capitalization growing its earnings at a 50% or higher rate of growth per year?
A company like an Exxon would be doing well to achieve and maintain a 10% rate of growth, yet many smaller companies can grow their earnings at a 50% or higher annual rate. Picture a WWII PT boat running circles around a battleship!
There was a time, in past history, when the company that has evolved into the Exxon Mobil of today did grow at a much faster rate but those days are long gone.
As Rupert Murdoch says, "The world is changing very fast. Big will not beat small anymore. It will be the fast beating the slow."
To increase the odds for success in the investor's favor, limiting selection of small cap stocks to the value category only, the investor is assured of not over paying in price.
To further increase the odds for success, the investor can introduce a 'timing' element into the strategy, through 'technical analysis', by the utilization of 'moving averages'.
For example, if a stock is trading above its 40 day moving average (40ma), and the 40ma is above its 80 day moving average (80ma), the stock is in a rising trend which, clearly, is always the best time to be buying stocks, is it not?
Finally, one must not ignore the risk vs. reward factor through proper trade management.
Determine in advance, before entry, under what conditions the trade will be 'kicked out'.
Through the judicious use of stop-loss orders, say 15% or 20% below entry, and/or if the 40ma crosses below the 80ma, whichever occurs first, would be a good rule to follow.
Risk can also, initially, be 'fixed' in place through the purchase of a put option, for protective purposes, in combination with the purchase of stock.
Rather than purchasing the stock itself, purchasing a call option as a substitute for the stock, introduces 'leverage' into the strategy along with the limitation of risk.
What are your thoughts on this subject? Share them!
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