Why It’d Be Foolish to Give Up on Small-Caps

By Friday, April 26, 2013

Foolish to Give Up on Small-CapsSmall companies tend to perform well coming off a recession like the one we had in 2008.

The beginning of the year was excellent for small-cap stocks as the Russell 2000 led the way with a 12% advance in the first quarter, including a 6.2% move in January.

We have been seeing some flight to safety in the risk preference of investors.

April has seen some profit-taking emerging in small-caps, as the Russell 2000 is down 2.3% as of Tuesday’s close and is currently trailing the blue chips and the S&P 500. (Read “Investors Down-Shift Risk, Search for Safety Ongoing Theme for 2013.”)

And with the economy continuing to strengthen in housing, manufacturing, and retail sales, small-caps will continue to have good upside potential.

The chart of the Russell 2000 below shows the upward break from the bullish ascending triangle. There’s some stalling and some potential for a relapse to back below 900, based on my technical analysis.

$RUT Russell 2000 small cap index stock chart

Chart courtesy of www.StockCharts.com

As we move forward, a lot of what happens to small-caps will be dependent on the ongoing strength of the economic recovery.

The key to investing in small-cap stocks is diversification and risk management.

Simply the risk is much higher when buying small-cap stocks. For instance, the emergence of bad news could drive small-cap stocks down 40%, while for a large-cap such a The Procter & Gamble Company (NYSE/PG), we would likely only see a decline of a few percentage points.

You should be sure to never load up on a sector and diversify across market caps and risk instead. In this way, you can achieve higher overall portfolio returns by adding small-cap stocks.

Add too many small-cap stocks, and you are vulnerable to excess selling if the market turns.

So in spite of the current pressure on small-cap stocks, I favor smaller companies for long-term growth, as the valuations tend to be more attractive and worth a look for aggressive investors.

And while the buying of large-cap stocks will always be an integral part of your portfolio, I suggest that you add some small-cap stocks for added overall portfolio returns.

Take the opportunity to buy on dips, as we have seen with small-cap stocks.

Also, be careful; the risk heightens if the economy turns against us, which would leave small-cap stocks at risk.

Of course, no reward is without risk, and in my view, small-cap stocks are still attractive.

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 »