Small-cap Stocks—Drop Them or Keep Them in 2012?

What Investment to Stick with if the Economy StrengthensYou would have done better investing in a T-Bill in 2011 versus small-cap stocks, which were negative last year after advancing 25.28% in 2010. The flat economic renewal in the U.S., continued stalling in Europe, and signs of slowing in China were negative for small-cap stocks. This is 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% in 2011, but, by year-end, small-cap stocks rallied out of their bear market, minimizing the decline to a minor loss. But 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, 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.

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 go is semiconductor company Kulicke and Soffa Industries, Inc. (NASDAQ/KLIC). The stock has a beta of 2.83 versus the S&P 500. This means 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 2.83 times the move of the index; should the S&P 500 move down, KLIC would move lower by 2.83 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 and U.S. economies show renewed growth, look to small-cap stocks to outperform.

One of the worst areas for losses last year was that of reverse mergers, but will the situation improve in 2012? Read what I have to say in 2011—Year of the Bear for Reverse-merger Stocks.