The Great Opportunities in Small-Cap Stocks


For the past year we’ve had our eye on one index.

And for most of the time it hasn’t been a pleasurable experience.

In fact, if you accused us of being masochistic by frequently looking at the chart…well, we couldn’t argue with you.

But that started to change from Christmas Eve.

That’s when the index that was causing so much pain, finally turned. We’re talking about the S&P/ASX Emerging Companies Index [ASX: XEC]:

Source: Google Finance
Here’s why watching this index was so frustrating…

Most times at the beginning of a stock rally it’s the small-cap stocks that take off first. Why? Because that’s the time when buying stocks seems crazy. The market may have fallen or tracked sideways for a time.

When stocks behave that way, the last people you expect to jump into the market are the investors who are looking for safe and low-risk stocks.

The investors usually attracted by falling or sideways markets are those looking to buy some of the riskiest and most beaten-down stocks on the market, namely small-cap stocks.

But you know what they say, ‘past performance isn’t a guarantee of future results’. That was certainly true in 2012.

Sure, stocks took off early in the year. But it didn’t last. Because when blue-chip stocks kept running, small-cap stocks didn’t. Figuratively speaking, small-caps fell off the perch on to the floor…and then fell off the floor into a hole!

But things started to look up again over the Christmas holiday and through January. The question for small-cap investors (heck, any investor) is whether the rally can continue.

We’re betting it can, and here’s why…

It’s important to look back and figure out why high-risk/high-return small-cap stocks didn’t do as well as the relatively safe and lumbering blue chip stocks.

The answer is dividends. That’s right, it sounds counter-intuitive. Dividend stocks are supposed to be low-growth stocks. They’re supposed to be the stocks that have finished growing and so they choose to pay excess cash as a dividend rather than growing the business.

Because of that, typically (but not always) dividend-paying stocks lag growth stocks. But that’s not how things have shaped up over the past year.

Since last February big dividend payers Commonwealth Bank [ASX: CBA] and ANZ Bank [ASX: ANZ] are up more than 22%, while growth stocks BHP Billiton [ASX: BHP] and Rio Tinto [ASX: RIO] are barely breakeven.

That’s all due to falling Aussie interest rates. Investors, especially retirees living off investment income, saw their income drop as the Reserve Bank of Australia (RBA) started cutting interest rates. In order to protect their income they’ve had to take more risks.

That means shifting out of safe bank savings accounts and buying dividend-paying shares. Make no mistake, that’s a big shift, and it shows that investors are desperate to move from almost risk-free savings account to much higher risk share investments…just so they can maintain their income.

But as we say, that trend may have changed. Having lagged blue-chips, small-cap stocks started to regain some of the lost ground during the first month of the year. Our bet is that this will continue.

Yes, analysts predict the RBA will cut rates further this year (the RBA’s first meeting of 2013 is next Tuesday), but having pushed blue-chip dividend stocks up so far already, many of those stocks are far from being the type of safe and stable income stocks most savers are looking for.

They are what we call, ‘priced for perfection‘. That means the share price has already built in every possible bit of good news. If the company disappoints the market by not growing profits or by not increasing the dividend fast enough, the share price could fall hard.

So if buying dries up for the big stocks, investors and fund managers will have to look elsewhere. That means looking for growth and value plays. That is, stocks that have the potential to grow quickly, and those trading at a big discount to fair value.

Looking at the chart above, and based on what we’ve seen in the market, there are plenty of great opportunities in small-cap growth and value stocks at the moment.

As always, investing in small-caps isn’t risk free, but we’ve said for some time now that small-caps are trading at the best valuations since 2009. And if 2009 taught us anything it’s that when a rally starts you’ve got to be quick, because before you know it other punters will have snapped up these stocks and it may be a while before the next great opportunity appears.

There’s no question in our mind that fortune is favouring small-caps at the moment, and that looks set to continue over the coming months.

Kris Sayce
for The Daily Reckoning Australia

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Kris Sayce
Kris Sayce, dubbed the ‘Jeremy Clarkson of Australian finance’, began as a London finance broker specialising in small-cap stock analysis on London’s Alternative Investment Market (AIM). Kris then spent several years at one of Australia's leading wealth management firms. A fully accredited advisor in shares, options, warrants and foreign-exchange investments, Kris was instrumental in helping to establish the Australian version of the Daily Reckoning e-newsletter in 2005. He is currently the Publisher, Investment Director and Editor in Chief of Australia's most outspoken financial news service — Money Morning.

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