Small-caps in a Bear Market,
But Have a Long-term View

By Thursday, September 29, 2011

Small-caps were the winners last year, advancing 25.28%. This was not a big surprise, as small companies generally perform better while the economy recovers from a recession.

So far this year, the small-cap Russell 2000 is lagging, as we near the end of the third quarter, down 13.71% as of Wednesday versus -3.34% and -4.00% for the DOW and NASDAQ, respectively. The Russell 2000 is down nearly 22% from its 52-week high and is in a bear stock market. While you may want to hold off on loading up on small-caps at this time, the valuations are becoming quite attractive and may be worth a look for investors.

And while I view the holding of large-cap stocks as an integral part of your portfolio, for added overall portfolio returns, you need to add small-cap and mid-cap stocks. These stocks add to the risk component of your portfolio, but you are compensated by a higher overall expected return from your investments.

Basic modern portfolio theory tells us that you can increase the expected return of a portfolio by simply adding more risk. This is the advantage of adding small-caps.

It may sound complicated, but it’s quite simple. Think of it this way. When you buy a stock like General Electric Company (NYSE/GE), it’s considered a “widow stock,” in that it can be held for the long-term without you having to actively monitor it. Of course, this used to be the case, but it simply no longer applies; however, for argument’s sake, let’s categorize GE as a safe play.

GE is what we term a “blue-chip” stock—a large-cap company that has a history of steady revenues and earnings and pays a dividend. The company growth tends to be stable and holds little surprise. The expected return from the stock tends to be a mix of dividends (income) and a small growth component. Investors who buy GE tend to choose the stock for its steadier performance over time, which has been proven over a long period of time.

A standard and simple measure of stock risk versus the market is called “beta”—a quantitative measure of systematic or market risk that cannot be diversified away and is generally in relation to the S&P 500 or another market/benchmark.

A beta of less than one implies that a stock has less risk than the market and hence less expected return, whereas a beta of greater than one implies a higher comparative risk versus the market, meaning possibly higher expected returns

As an example on the small-cap side, take a look at semiconductor company Kulicke and Soffa Industries, Inc. (NASDAQ/KLIC). The stock has a beta of 2.92 versus GE’s beta of 1.85. This means that KLIC incorporates greater risk than GE and both have higher risk than the S&P 500. In addition, the two stocks will tend to move in correlation to the broader market.

For instance, should the S&P 500 move up, KLIC would move up by 2.92X the move of the index in theory; should the S&P 500 move down, KLIC would move lower by 2.92X the amount the index moves down.

When markets rally, high beta stocks will tend to fare better. But a note of warning—buying only higher beta stocks does not necessarily translate into higher returns, as it also results in greater volatility and downside risk when the broader market declines.

To increase the overall risk of your holdings, you need to increase the expected return. The most important fact to understand is that you can increase the risk-reward profile of your portfolio by adding small-cap stocks and/or sectors that have higher growth potential.

If the global economies settle down and show renewed growth, look to small-caps to outperform.

About the Author, Browse George Leong's Articles

George Leong is a senior editor at Lombardi Financial. He has been involved in analyzing the stock markets for two decades, employing both fundamental and technical analysis. His overall market timing and trading knowledge are extensive in the areas of small-cap research and option trading. George is the editor of several of Lombardi Financial’s popular financial newsletters, including Red-Hot Small-Caps, Lombardi’s Special Situations, Judgment Day Profit Letter, Pennies to Millions, and 100% Letter. He is also the editor-in-chief of a... Read Full Bio »