Why the Best Opportunities Are in Small-cap Stocks

small cap investmentsAt this juncture, the market is holding, but will likely face some selling pressure as it edges higher. At this stage, this continues not to be a “buy and hold” market, but success will largely depend on stock-picking and not just randomly buying stocks after the market declines.

The key is to look for companies that have fallen off, but that are at levels where the downside risk is far less than the upside potential for strong price appreciation. Of course, there is no evidence that stocks have bottomed out, given that the negative and bearish sentiment remains towards stocks.

Yet, at the end of the day, looking for stocks that may be bottoming is an excellent strategy to get above-average returns down the road. Be aware that there will be near-term volatility in these stocks.

At this time, I believe that the best opportunities are in small-cap stocks. The small-cap Russell 2000 leads the pack, up nearly four percent this year, versus less than one percent for both the DOW and S&P 500.

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Wall Street typically focuses on just a handful of large-cap stocks. The rest fly under the radar, being largely under-followed and, therefore, by extension, largely undervalued.

Why? Simply put, for big Wall Street firms, there is no money in following small- and micro-cap companies. As a result, regardless of how good a story behind a company is — and regardless of how strong its fundamentals are — Wall Street continues to ignore this rather large pool of good investments.

The Street has grown over the years. Big banks have bought out small independent brokerages and small independent brokerages have kept on merging amongst each other to grow into bigger ones. This has left small-caps out in the cold, with no one interested in promoting stories that brought in little in fees. These days, brokerages make money only if they promote the most liquid stocks, which are in turn only large-caps. You could call it the catch-22 of 21st century investment banking.

There is one more reason why the Street does not research small-caps. That reason is trading margins or, rather, the lack thereof. Namely, as competition among brokerages became more and more cutthroat, trading margins became narrower and narrower. Today, no trading desk has “play money” to spare for speculating on development-stage companies. Plus, only large-caps are liquid enough to keep those trading margins safe.

As with everything else, there are pros and cons when it comes to investing in small-caps. However, one of the biggest pros is value. There are so many great little companies that no one has ever heard of before. There are companies with breakthrough science behind them and companies operating in a niche market. Yet, because Wall Street is focusing on large-caps, their stories go undiscovered and their stock prices go undervalued for years on end. This is where we come in to provide a bridge between Wall Street and independent research.