But first let’s understand where “cap” comes from.

When analyzing a company, the most important thing to look at is how much it is worth, or at least how much the market thinks it is worth. That’s called the company’s market capitalization, or “cap.” Here’s how it is figured out…

Say Company X has 100 million shares outstanding and a price of $12 per share. That would give it a market cap of $1.2 billion. The market cap is just the number of shares outstanding multiplied by the cost per share.

But the classification of company sizes is the key idea. For instance, a large-cap (market cap of over $10 billion) cannot grow as much and as fast as a small-cap ($100 million–1.5 billion). Certainly, a microcap (under $100 million) can grow even faster, and a mid-cap ($1.5–10 billion) falls somewhere in between.

[Side note: For our purposes, we’ll combine small- and microcaps… So everything under $1.5 billion will be a small-cap.]

History sides with small-caps. Rolf Banz made a famous study back in the early 1980s, called “The Relationship Between Return and Market Value of Common Stocks.” In this important report, Banz found that over the 50-plus years he studied, the smaller the company, the larger the average return. This held true for all the years he studied, regardless of whether the market ended the year up or down.

Here are the exact results:

As you can see, if you had invested in the smallest companies over that period, you would have made nearly five times what you would have had you invested in the blue chips.

That’s the simplified reason why we love small-caps. So why don’t we call ourselves the Small-Cap Sleuth? Well, we like to break it down even further. Let me explain…

Penny Stocks vs. Small-Caps

Let’s return to our previous example…

Company X has a market cap of $1.2 billion (100 million shares times $12 per share). That’s a small-cap company, but not a penny stock. Penny stocks are defined as anything with a market cap under $1.5 billion (hence, they are all still small-caps) and a price per share under $10. So you can see Company X doesn’t fit both requirements. Therefore, we wouldn’t recommend it.

Now, let’s say Company X has a 2-for-1 split (meaning if you owned one share before the split, you’d own two after). Now there are 200 million shares, but the share price is only $6. That would make it a penny stock. It now falls perfectly within our range.

So why would we recommend only penny stocks? Well, there are a number of factors…

First, there is market psychology at work here…

When certain investors see a $6 stock, they think it’s cheap. This may not be the case. If it had the same market capitalization at $50 per share, the investor wouldn’t think that way. So penny stocks look considerably cheap compared with other small-caps.

That’s one reason. Another is buying power.

With penny stocks, it is far easier to buy more shares as well as diversify between companies. Say you have four companies you’re interested in buying, but only have $100 to spend. If they are all $50 a pop, you can’t do it. Now, if they are all $5 per share, you can get into all of these positions. Thus, buying a diversified portfolio.

The third reason for picking penny stocks over more expensive ones is the price itself.

If a company is sitting at $50 per share, it takes $5 swings to really start seeing profits or losses. With a $5 company, it takes only about 50 cents, which can easily be done in a day of trading. The smaller the price per share, the larger the price swings. That’s how short-term penny stock traders have been making millions over the years.

Whether you are a short-term investor or in it for the long haul, you can see that small-caps, and specifically penny stocks, are the way to go.

The truth is we love small-caps. It’s far easier for a $100 million company to double than it is for a $100 billion one. It’s as simple as that…

Sincerely,

Jim Nelson
June 30, 2008

P.S.: Over the years, many have tried to refute Banz’s study. Critics say that it doesn’t factor in companies that go belly up and fall off major exchanges. There is some merit to this. So instead of blindly picking small-caps to invest in, it’s good to have someone in your corner.

Investing in Small-Caps was originally featured in the Penny Sleuth.

He had a lot of success managing money in the happy market before things turned ugly in 1973-74. “Stocks we had went from 10 times earnings to six times earnings,” Sosnoff reflects. “There I was, Ahab, tangled in my own harpoon whale lines and being carried down to the depths by the malevolent great white whale. Of what did it avail that all my earnings projections were uncannily accurate? We were buried just the same.”

All of which is to say there is nothing quite like the right stock at the right time. One interesting guidepost to look at is the longer-term market cycles of what’s in fashion and what’s not.

Which brings me to one of my favorite charts. It is a conceptual portrait of market history — stretching back to 1977. Take a look at “The Tree Rings of Markets Past.” This chart marks off the booms and busts of various sectors. You see fat eras of plenty, bulging like swollen rivers after a rain, and you see thin areas of hardship, like parched desert sands:

It shows you the market capitalization share of the S&P 500 by sector. The S&P 500 Index, a popular stock market index made up of 500 stocks, is broken down into 10 sectors, as you can see. Market capitalization is the value of the sector in the marketplace. As stocks rise, market caps swell.

Looking at the chart, you can see what’s been popular. In 1980, the energy sector was hot and grew to represent nearly one-third of the S&P 500. It collapsed thereafter, and energy sector investors took a beating.

In the 2000 bubble, you can see how technology stocks came to represent an even greater share of the stock market, nearly 35%. I’m sure I don’t need to recall how badly mauled investors in technology were as the bubble popped.

The folks who make the S&P 500 Index are always adding and subtracting names from it, so it’s not a true representation of what these sectors did. But the Index still manages to capture the spirit of the past rather well.

I love this chart for all that perspective it gives in one glance. And because it shows how great tides shift in the market. Now unfolding is another great shift.

You can see how financials have come to represent a sizable piece of the S&P 500. Today, they make up over 21% of the whole. Financials have enjoyed a long stretch of prosperity. If the past is any guide, you want to avoid the dominant sector.

Even if you didn’t know anything about the market’s tree rings, you’d want to avoid most financials now. With cracks in the mortgage business giving way, the financials are under significant pressure for the first time in a while.

As John Hussman of Hussman Funds shows, financial stocks have many marks against them, generally speaking. Bank reserves against loan losses sit at a 32-year low. Yet overall net charge-offs are up 50% from a year ago. “Given the thin coverage of the banking system for such losses, rising charge-offs and loan loss reserves are likely to bite deeply into earnings,” writes Hussman.

Historically, the best time to buy financial stocks is when the group trades for about book value. Yes, as Hussman points out: “Currently, the typical multiples are two and often three times that level.” Most financials, he says, “are only ‘cheap’ based on comparisons with very recent norms and on the assumption that the high profitability levels of recent years will be sustained indefinitely.”

But let’s get back to that chart for a minute…

The energy sector — even after taking a much larger part of the pie — is far from danger levels. As recently as July 2004, energy was sitting there at only six and change. It has expanded since by a sizable margin. Yet even today, it’s less than 10% of the S&P 500 — far from bubble levels.

If avoiding the fattest sectors proved helpful, then perhaps giving the skinny sectors a good look might be a good idea. In that vein, note the squeezing of basic materials so tightly it barely registers on the chart.

What is the basic materials sector? It’s all the companies that do the dirty work and bring up metals like copper, nickel and zinc. It’s all the stuff that we need to build pipelines and power grids and more.

Nothing lasts forever. Things won’t always stay bad and can’t possibly stay good. This is some of the most elementary investment thinking but is painfully true. If you can keep an open mind and remain patient, the goldmine you missed years ago may be right in front of your face before you know it.

Sincerely,

Chris Mayer
January 10, 2008

P.S.: This basic materials sector should be pretty familiar to you. We’ve talked many times here in the Sleuth about the importance of these materials to our growing infrastructure needs. I truly believe that this theme will be here to stay for quite a while. I’m so sure, I even wrote up this report on one specific type of infrastructure play…

Investing in the Most Undervalued Sector was originally featured in the Penny Sleuth.