Market Buzz – Why Small-Caps?

Posted by Ryan Irvine - KeyStone Financial

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For starters, how about the fact that KeyStone has recommended six (profitable small-cap stocks) to start 2015 – each one has already produced significant gains.

In fact our top rated Cash Rich Canadian Software small-cap has now produced a tremendous 123.13%  gains since mid-January, after jumping nearly 30% in one day this week on the announcement of another game changing contract. Despite the gain, the market is only starting to catch on to the potential of this company and it still ranks as a BUY!

Our top ranked, value-priced Canadian Specialty Pharmaceutical small-cap is up 59.43% in the past 2-months, but still trades at a significant discount to its peers and all large-caps in its sector – despite its superior growth profile.

KeyStone’s recommendation in late 2014 of a profitable cash rich small-cap that is servicing the semiconductor segment has jumped 56.52% in the last month and a half. The stock just posted record 2014 annual earnings this week (we have updated our clients on this) and reported and unexpectedly high backlog that bodes well for the next quarter.

In fact, the “laggard” of this group of 6 profitable Canadian Small-Cap is up 12.70% in the last month and pays us a healthy 7% dividend!

These gains were produced against the backdrop of Toronto’s main market, represented by th TSX Composite Index, posting a gain of just over 2% in the first quarter.

Why have these recommendations been so successful (other than because of the countless days and endless nights we put into the research behind them)? Quite simply, these stocks fly under the radar – they are underfollowed and the potential to uncover true value is real.

Heck, the proof as they say, is in the pudding.

Come to think of it, I have never had much luck finding great stocks in my pudding. The proof is in the results.

If two or three of these stocks above made it into your portfolio to start 2015, you would already be off to a smashing start!

But three months is not an extremely strong sample size. Do small-caps actually stand the test of time?

Let’s examine that.

Between 1926 and 2004, large-cap stocks had an average annual return of about 9.26%. Accordingly, $10,000 invested in large-cap stocks in 1926 would have grown to about $10 million by 2004. That’s not too shabby. However, it pales in comparison to the astonishing 15.9% annual return of small-cap stocks over the same time period. $10,000 invested in small-cap stocks in 1926 would have grown to about $1 billion by 2004! There is also a famous Ibbotson study, which examined the U.S. markets over 70 years and found that small-cap stocks outperformed large-cap stocks 79% of the time over a 15-year period and 95% of the time over a 20-year period.

Small-Caps Vastly Outperform Large Cap Stocks (historically)



But why do small-caps outperform their large-cap brethren?

By Before Big Institutions Can Buy

The universe I can’t play in has become more attractive than the universe I can play in. I have to look for elephants. It may be that the elephants are not as attractive as the mosquitoes. But that is the universe I must live in.”

– Warren Buffett, discussing the advantages of small-cap stocks

Just like the Buffett quote above states, you have an advantage buying at the small-cap level. It is one of the biggest advantages of investing in small-cap stocks and gives you the opportunity to beat institutional investors. Because mutual funds and other investment vehicles have restrictions that limit them from buying large portions of any one issuer’s outstanding shares, many funds will not be able to give the small cap a meaningful position in the fund. As small-cap investors, we can buy in early and benefit from institutional buying down the road as the company grows and larger investors are able to buy in – often providing better liquidity and pushing the valuations higher.

Lack of Coverage Creates Potential Small-Cap Bargains

In many cases, when Keystone discovers a small-cap stock, we are initially the only official research coverage on the stock and almost always the only independent analysts covering the stock. Compare this too many large-cap stocks which have hundreds of analysts analyzing and following their every move. You can immediately see why the potential to find an undervalued and undiscovered gem is far more likely in the small-cap segment of the market. This is one of the primary reasons why we apply our fundamental research to this area of the market, where we can truly add value and find the best growth and value stocks for your portfolio.

Small-Cap Have Higher Growth Prospects

Due to their size alone, small caps typically have higher growth rates than larger companies. At a basic level, it is easier to double earnings of $1 million to $2 million then to double earnings of $1 billion to $2 billion. However, the market often under prices small caps relative to similar larger companies. That means investors are typically getting better value for their investment dollar with the type of small-cap companies we recommend through our research service due to their growth potential, often not fully recognized by the market because of lack of analyst coverage.

Small-Cap Volatility Creates Opportunities

To be clear, small-cap stocks are intrinsically more volatile, you also need to exercise extra care in examining their fundamentals. Small caps higher relative volatility stems from their relatively low liquidity. This means there are fewer shares available to buy or sell on the open market compared to larger companies, so small caps can move fast, even on relatively small pieces of information or news. For the savvy and well-researched investor, this can mean quick or long-term (as is most often the case) sizable gains. For those who fail to do adequate legwork, steep losses can just as easily be the result.

The financial crisis of 2008 presented generational buying opportunities and our 15 BUY (5 months following) recommendations in the wake of this crisis have made many of our client’s excellent returns. Corrections and other mini-crisis’ will continue to provide excellent opportunities for the savvy investor. The key is to have an experienced navigator constantly evaluating and identifying long-term opportunities in all market conditions with the singular goal of providing you with strong, long-term growth for your portfolio.

Investing in a selective group of individual stocks poised for rapid growth and trading at attractive valuations can deliver big gains and improve the total return for your overall investment portfolio. This is precisely what KeyStone’s Small-Cap Research Service is designed to do for you!

Our final tip is in reference to diversification – “Diversify, But Do Not Over-diversify” – Try to avoid accumulating too many stocks that operate in the same sector (or similar industries) or are dependent on the same geographies, or reside in the same risk category (cyclical, defensive, etc). Within your 8 to 12 stock Small-Cap portfolio, you will have room to diversify into a multitude of different industries and geographies. Having said this, we believe in focussing on a manageable number of great stocks rather than a shot-gun approach which sees many average investors holding 30-150 or more individual stocks in a growth stock portfolio. Avoid this strategy or just buy an index ETF and call it a day.

You cannot beat the market if you are the market.