Look to Higher Beta Small-Caps to Increase Portfolio Returns

Increase Portfolio ReturnsSmall-cap stocks performed better than both the S&P 500 and the DOW in what was a cautious November, as the economy showed encouraging growth in several key areas. Early on in December, small-caps are leading with a 0.12% advance versus a 0.64% decline for the S&P 500. The Russell 2000 is above the only key index that’s above its 50-day and 200-day moving averages (MAs), based on my technical analysis.

In 2011, small-cap stocks underperformed. You would have done better investing in a T-Bill versus small-cap stocks, which were negative in 2011 after advancing 25.3% in 2010. Yet the encouraging signs of economic recovery from the 2008 Great Recession in manufacturing, the housing market (read “Why the Housing Market Is Promising but Overextended”), and the jobs market are helping to attract some buying to small-cap stocks, which generally perform better as the economy recovers from a recession.

I continue to favor small-cap stocks for long-term growth 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, I like 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. 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 a 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 a stock has less risk than the market, hence, less expected returns; 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 1.73 versus the S&P 500, which implies that Kulicke and Soffa 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, Kulicke and Soffa would move up by 1.73 times the move of the index ; should the S&P 500 move down, Kulicke and Soffa would move lower by 1.73 times. This is reflected by the comparative performances over the past 52 weeks, in which time Kulicke and Soffa advanced 21.2%, well ahead of the 11.6% in the S&P 500. Kulicke and Soffa advanced 83.0% higher than the index, which is pretty close to the beta’s estimate of around 73.0%.

KLIC Kulicke and Soffa Industries Nasdaq Stock Market Chart

Chart courtesy of www.StockCharts.com

When there’s a stock market 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 and U.S. economies show renewed growth, look to small-cap stocks to outperform.