Professional Investment Services

Buy Small Caps Now While Investors Are Crying

‘Buy when they’re crying, then sell when they’re yelling,’ could comprise Chapter One of the contrarian investor’s handbook.

The idea being that when prices are well below any logical level, pushing investors past their pain threshold, forcing them to sell on an emotional basis – THAT is the time to go against the flow and snap up a bargain.

And conversely, when investors are overexcited, and the forums are full of revved up punters talking about the Maserati they’re going to buy with their profits…THAT is when you sell!

Right now, after close to two years of falling markets, small-cap investors are really starting to throw in the towel.

 

Adding insult to injury, small-caps have kept falling even as the ASX200 has picked up since July this year.

This particularly lousy performance from small-caps means that small-cap investors are well behind the rest of the market. But the crying has now reached levels not seen since the death of Kim Jong-il. That suggests that now could be the time to buy…

Since May last year, the ASX200 (red line) is down 8% (though recovering).

In comparison, the Small Ords (yellow line) is down 23%.

Another index of even smaller companies – the Emerging Companies index (XEC: blue line) – has crashed 32%.

So small-cap investors have every reason to cry.

Buy when they’re crying…? Well small-cap investors are crying now

 


Click here to enlarge

Source: Google Finance

 

There are a few reasons why these small-cap indices have fallen despite a rising broader market in recent months.

For one thing, they contain a large number of small mining companies, and the whole mining sector has been belted this year.

Secondly, funding has been very hard to come by in 2012, as I said in Money Morning last week. They just can’t get cash to fund their ambitions when they need it:


‘The secondary market, which is what companies use to top up the kitty, has fallen from $42 billion last year – to just $17 billion worldwide this year: a stunning drop of 60%.

‘And the primary market, for listing new companies, has been smashed from $27 billion to just $5 billion globally – A drop of over 80%!’

And it is the small companies (that are years from producing cash), which are dependent on this lifeline. If their cash dries up, the price falls. And those that manage to get funding have seen their share price fall in reaction to the anticipated share dilution.

The result is that the Emerging Companies index has now fallen to its lowest level in history.

But as another contrarian investors saying goes, ‘Buy when there is blood on the streets.’

And when small-caps are so far out-of-favour that indices are setting new lows, the bargain hunting contrarians come out to play.

Position for a Rally in Small Cap Stocks

 

The reason is that this could be exactly the time to get set and ready for a coming rally.

The reason to take on this risk is the incredible performance small-caps put in when they rally.

For example, when the ASX200 rallied 56% in the two years from March 2009, the Small Ords index gained 101% in the same timeframe.

Small-cap index gains almost twice as much as the main index

 


Click here to enlarge

Source: Google Finance

 

So small-caps can accelerate your market gains – the trick is knowing when to get in.

Just because it’s cheap, doesn’t mean it won’t get cheaper yet. But at some point, the value will be so astonishing that the worm will turn.

Maybe the catalyst will be the effects of QE3 (money printing), which I suspect are about to wash through the market. The program has only just started in earnest, and if history is any guide, this will be a good time to have another look at small-caps.

My mate Kris, the regular Editor of Money Morning, thinks the timing couldn’t be any better. He’s been tipping small-cap stocks furiously for the last few months in anticipation, and now has more small-caps on board than he’s had in years. As he says in a new report:


‘As of 26th November there were 2,076 companies listed on the Australian Stock Exchange (ASX).

’1,470 of them trade shares for 50 cents or less.

‘Right now the All Ordinaries – the index of Australia’s biggest companies – is down 35% from its 2007 peak.

‘So buying a load of stocks from the RISKIEST end of the market might seem downright stupid to you.

‘But it’s at times like these when it’s the best time to buy.

‘In fact I haven’t seen a better time to take a few calculated risks on small company stocks since the market collapsed in August 2008.’

Last time I saw Kris pull this manoeuvre, a year later he had a long list of multi-baggers, i.e. 100%, 200%, and 300% gains, on his recommended buy list.

So Kris is certainly doing the ‘buy when they’re crying’ part of the mantra.

So when he’s high-fiving himself and doing laps of the office this time next year, I’ll have to remind him about the ‘sell when their yelling’ part!

Dr Alex Cowie
Editor, Diggers & Drillers