Investment Contrarians

Why You Need Small-Cap Stocks to Boost Your Profits

By for Investment Contrarians |

Small-Cap Stocks to Boost Your ProfitsSmall-cap stocks will be a key driver of the broader market should the U.S. and global economies continue to improve. In 2012, small-cap stocks trailed only the technology sector as far as performance. The Russell 2000 has been advancing since the end of the first quarter, with its greatest advancement in December. If 2013 is a strong year for the economy, small-cap stocks will deliver.

My stock analysis tells me that what happens in January will be an important indicator for the year as far as performance. Historical records indicate that stocks have increased an average of 1.6% in January since 1969, according to the Stock Trader’s Almanac. In 2012, January was a strong month, so it was not a surprise to see the relatively good advance in stocks.

I 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 a 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 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 stock.

A beta less than one implies that a stock has less risk than the market, meaning lower expected returns; whereas a beta 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 Industries 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 upward, Kulicke and Soffa Industries would move upward by 1.73 times the move of the index; should the S&P 500 move downward, Kulicke and Soffa Industries would move lower by 1.73 times. This is reflected by the comparative performances over the past 52 weeks, during which Kulicke and Soffa Industries advanced 24.7%, well ahead of the 13.0% in the S&P 500. Kulicke and Soffa Industries advanced 89.0% higher than the index, which is pretty close to the beta’s estimate of around 73.0%.

Kulicke and Soffa Industries Inc Chart

Chart courtesy of http://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 greater growth potential.

If the global and U.S. economies show renewed growth, look to small-cap stocks to outperform this year.

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