Never Mind the Blue Chips; Small-cap
Stocks Are Where the Money Is

Small-cap  Stocks Are Where the MoneySmall-cap stocks have been stellar in the first two weeks of September, with the Russell 2000 advancing an impressive, yet perhaps overzealous, 6.4%. The broader market, along with blue chips and technology issues, has also shown great stride. For the year, technology and small-cap stocks are leading the pack with the NASDAQ and Russell 2000 up 22.2% and 16.6%, respectively, as of the close of September 14.

In 2011, small-cap stocks underperformed. At that time, you would have done better investing in a Treasury Bill versus small-cap stocks, which were negative in 2011 after advancing 25.3% in 2010. Yet, the encouraging signs of the economic recovery from the 2008 recession in manufacturing, the housing market (read “U.S. Housing Market on Much Better Footing”), 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, because the valuations are more attractive and they 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 against the market is called beta—a quantitative measure of systematic or market risk that cannot be diversified away and generally exists 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 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

For small-cap stocks, semi-conductor company Kulicke and Soffa Industries, Inc. (NASDAQ/KLIC) is a good example. The stock has a beta of 1.8 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 1.8 times the move of the index; should the S&P 500 move down, Kulicke and Soffa would move lower by 1.8 times. This is reflected by the comparative performances over the past 52 weeks, during which Kulicke and Soffa advanced 33.8%, well ahead of the 20.5% in the S&P 500. Kulicke and Soffa advanced 64% higher than the index, which is pretty close to the beta’s estimate of around 78.0%.

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.