Small-caps Rally Out of Bear Market;
Time to Look at Buying Some

With the stock market rally over since the beginning of October, small-cap stocks have rebounded out of their bear market. George Leong discusses the benefits of owning small-caps as part of your investment portfolio, based on modern portfolio theory.Small-cap stocks were the winners last year, advancing 25.28%, which was not a big surprise, as small companies generally perform better as the economy recovers from a recession.

The small-cap Russell 2000 had been down over 26%, but with the stock market rally over since the beginning of October, small-cap stocks have rebounded out of their bear market, minimizing the decline to around four percent as of last Wednesday. Despite the rally, small-caps continue to trail blue-chip and big-cap stocks.

Even during the chaos, I continue to favor small-cap stocks as the valuations are more attractive and may be worth a look for aggressive long-term 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 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-cap stocks.

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.

An example as far as small-cap stocks is semiconductor company Kulicke and Soffa Industries, Inc. (NASDAQ/KLIC). The stock has a beta of 3.09 versus the S&P 500. This means that KLIC incorporates greater risk than the S&P 500 and will tend to move in correlation to the broader market, but at a faster rate.

In theory, should the S&P 500 move up, KLIC would move up by 3.09 times the move of the index, and should the S&P 500 move down, KLIC would move lower by 3.09 times.

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-cap stocks to outperform.

In the mining area, I like some of the smaller miners versus the large-cap producers. Read what I say in Why You Might Want to Look at Buying the Miners.

Within the small-cap area, I favor the technology group, which I discussed in Selective Tech Investing the Key to Success.