Why You Should Sell Your Small Cap Stocks
Tuesday, April 3, 2007 | Dylan JovineRating:
Today I’d like to start off with a bang by recommending that you immediately consider lowering your exposure to small-cap stocks (stocks with market values under $1 billion).The reason is simple: small-cap stocks are significantly overvalued. Indeed, they are even pricier, on average, than they were in March 2000, just before the Internet bubble burst. (In contrast, the average large-cap stock is moderately undervalued based on historical standards.)
The point is illustrated well in a recent study conducted by Ford Equity Research, which compared the difference in the P/E ratios between the companies in the S & P with the largest market caps and those with the smallest market caps.
According to the study, the average P/E ratio among the 50 largest-cap companies is now 19, about a third of the average of 60.7 for the biggest 50 in March 2000. The average market cap for the 50 largest companies is now $123 billion, versus $153 billion in March 2000.
Contrast those numbers with those for the 50 smallest companies in the index: their average P/E ratio is now 30.7, versus 20.3 seven years ago. And their average market cap is now $3 billion, versus $1 billion.
In other words, the smallest-cap stocks in the S & P 500 are significantly more overvalued today than they were seven years ago.
What does that mean for you?
The first point I would make is to encourage you to reduce your overall exposure to smaller cap stocks. You may want to start by eliminating any positions you may have borrowed money to buy. For example, if you own $10,000 worth of a small cap company on margin, sell the portion on margin.
It may leave you with only $5,000 worth of the same stock (assuming you were on 50% margin), but Rule #1 of successful investing is not to lose money. (Rule #2 is not to forget Rule #1.) Eliminating any borrowings on stocks that are already overextended is a good way to follow that rule.
The second piece of advice I would lend to you is to sell any small cap stocks that are overextended. Many traders would define “overextended” as a stock that has made a big move from its base. For example, if a stock has been trading between $10 - $13/share for the past six months and suddenly shot up to the $20 range, it would likely be overextended in price.
Of course, just because a stock moves higher in price doesn’t mean that it’s overextended. But if the underlying business itself hasn’t fundamentally changed, the stock may very well be overextended.
(If a company has been selling shoes for 100 years and growing sales and earnings at a conservative 10% rate each year, and its stock has suddenly moved up 50%, it has likely not been the result of a “fundamental change.”)
The suggestions I’ve discussed above are defensive in nature (i.e. designed to protect your wealth). I do have a recommendation to make that is more offensive in nature, i.e. designed to grow your wealth.
An easy way to profit from this information is to consider investing in an Exchange Traded Fund (E.T.F.) that favors large caps over small caps.
What exactly is an ETF?
Although there are important differences between ETFs and mutual funds, it’s helpful to think of an ETF as a mutual fund that tracks an index, a country or an industry sector.
Unlike mutual funds, though, ETFs can be purchased and sold throughout the course of a day; stop and limit orders can be placed; they can be sold short; and they may also be margined. Last, but certainly not least, many ETFs also trade options, similar to stock options.
There are hundreds of ETFs now available, tracking a myriad of different market and sector indices. Some of the different indices tracked by ETFs include the following:
* General Market Indices (e.g. S & P 500, Dow Jones Industrial Average)
* Sector Indices (e.g. S & P Energy Sector, KBW Bank Index)
* Fixed Income Indices (e.g. Lehman 20-Year Treasury Bond Fund)
* International Indices (e.g. DJ EURO STOXX 50, DJ Global Titans)
* Market Cap (e.g. Small-cap, Mid-cap, Large-cap)
* Investing Style (e.g. Value, Growth)
While there’s no guarantee, of course, that large caps will outperform small caps over the next five years — there’s a good enough argument to be made that they will.
Where Can I Learn More About ETFs?
The first place I would recommend visiting is www.ishares.com. Not only are there great descriptions of the ETFs available for trading, but they have great tools to help you learn a bit more about the instrument itself.
I’d also suggest keeping an eye open for a new ETF education guide being created by hedge-fund manager and Point & Profit Chief Teeka Tiwari.
In Teeka’s brand new ETF product, you’ll learn why most firms marketing ETF-related products (i.e. investment newsletters) are totally unaware of how to harness their true potential.
Teeka will also demonstrate one of the more remarkable investing lessons I’ve seen in recent years: how to turn $10,000 into $2.7 Million with ETFs.
Keep your eyes open.
Best Regards,
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Dylan Jovine
Chief Investment Officer
The Tycoon Report
