Why I switched to Micro-Caps

For those of you who actively follow the markets, you will remember this year’s turmoil. End of January saw a strong correction of the U.S. markets, a 12% drop on the major indexes.

It might not sound like much, but with a 20.5% gain over 2017, it meant to give back more than half the gains of the previous year. Ouch!

I hope you had your stops and risk management measures in place… this helped a lot to retain gains and/or minimize losses.

But that raised another question…

How to make higher profits?

Losses are inevitable, and sudden corrections are difficult to foresee and nearly impossible to time correctly. So one way to do better is to boost your gains. But how?

I decided to do some research about it! I wanted to know, where are the big winners?

And after going through my usual list of SP-500 components, I found a stock that did well: NKTR (Nektar Therapeutics).

I was dumbstruck.

NKTR made a spectacular gain of 500%. It’s in my primary “universe” of SP-500 stocks… and yet… I never noticed it. It fell through the cracks of my additional filters.

What else might be out there?

That’s what I wondered. How many are such strong gainers in my shortlist?

I decided to dig a bit deeper, and I asked myself: how “lucky” would I need to be to randomly choose “big winners”?

Answer: 3% (or 15 out of 503 stocks)

3%. That was over the last 12 months the probability to choose such a stock within the S&P-500 components that gained at least 100% over less than one year.

That’s not much, so my next question was: how well do S&P-500 stocks represent the entire market?

After all, the big tech companies, the Apples, and Facebooks are all there.

I could not have been more wrong about that.

But see for yourself. I scanned for 100+ percent winners in three categories:

  • S&P-500 Stocks
  • The entire US stock market (approx 4,600 stocks)
  • US stocks priced between 2 – 10 USD

Here’s the result:

Wait, what?? Yes… here in numbers how much stocks gained over 100% over 12 months:

  • S&P-500 Stocks: 3%
  • The entire US stock market: 18%
  • US stocks priced between 2 – 10 USD: 32%

It turns out, sticking to S&P-500 stocks greatly reduces your chances of hitting the “trading jackpot”!

Big Winners by Capitalization

When doing the same analysis but using market capitalization as the category, a similar picture emerges:

In a nutshell… large companies grow slower than small ones. Not such a big surprise. But I never imagined that the effect would be so pronounced.

But there is more!

Small companies that do well have another advantage: their stock price tends to be sector independent.

It means if the industry sector tanks… that stock, more often than not, will stay on track and continue to increase in price.

Be careful though…

Over the last 2 months, I sold many of my mega and large-cap stocks and instead invested in small and micro-cap companies.

This switch was not as easy as I anticipated and I learned a couple of valuable (read: expensive) lessons along the way:

  • Small and micro-cap stocks are much more volatile than large caps. Sudden drops of 25% or more are common.
  • Setting stops and managing risk is even more important. High volatility makes it more difficult to apply.
  • It’s much more work! Investing in low cap companies is a bit like investing in startups… better do a lot of due diligence.
  • Portfolio volatility increases and these value swings cause more stress.
  • Margin requirements: because of higher volatility, investing on margin is limited by your brokerage, i.e. you cannot borrow as much money as you might be used to with large-cap stocks

In conclusion…

Investing in smaller companies can be incredibly beneficial.

But it means higher risks and much more work to stay on track – so I would only recommend it for more experienced traders.

Happy trading!



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