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When the News is Bad, it’s Good to be Small

By Jim Pearce on March 28, 2018

The stock market’s powerful rise over the past five years has created trillions of dollars of new wealth, at least on paper. From the start of 2013 thru end of 2017, the S&P 500 index increased 83% while the tech-heavy Nasdaq 100 index gained 133%.

Some individual stocks did considerably better than that. Facebook (FB) grew by more than 500%, while Netflix (NFLX) increased by an astonishing 1,360%. That is great news for their shareholders but it has also created a stock market environment that is “priced for perfection”, hypersensitive to even a whiff of disappointment.

That’s why the average reading of the VIX, or stock market “fear index”, has skyrocketed 50% higher so far this year than for all of 2017. The concern reflected by the rising VIX is not over corporate profits or the economy; by just about any measure, American industry is firing on all cylinders.

However, recent talk of trade wars, budget deficits, and interest rate hikes has reintroduced the notion of “headline risk” into our daily lexicon. Every word uttered by politicians, central bankers, and corporate executives are parsed for hidden meaning, sometimes with disastrous results.

Facebook (NasdaqGS: FB) CEO Mark Zuckerberg’s inept attempt at an apology for his company’s massive data breach last month sent its share price down 10% in a week (and wiping out $50 billion in paper wealth in the process). Since then, it has declined another 5%, wiping out nine months’ worth of gains.

Heard but Not Seen

As Facebook’s recent fiasco illustrates, owning stocks that fly under the radar is a good way to avoid headline risk. When a major story breaks about something that might affect the stock market, the companies that will be impacted the most are the first ones to go under the microscope.

That’s why shares of Boeing (NYSE: BA) dropped more than 10% during the past month. It takes a lot of steel and aluminum to build jets, so Boeing stands to be one of the biggest losers if its cost for buying those materials skyrockets as a result of a trade war.

Of course, Boeing has hundreds of much smaller vendors and suppliers that would also be adversely affected by the same event, but few people know their names. The companies that comprise the S&P 500 is where most of the attention goes these days, due in part to how much 401(k) money is invested in index funds tracking those same stocks. Not so for small-cap stocks.

A side benefit of owning small-cap stocks is that they are less vulnerable to excess volatility caused by speculative options trading. Professional short-sellers require huge volume on put options to ensure adequate liquidity. There is no point in buying an option if there won’t be someone else to sell it to when it’s time to get out of it.

Price Check

Another advantage to owning small-cap stocks during periods of excess stock market volatility is that they some of them tend to become grossly mispriced relative to the size of their market opportunity. That seldom happens with large-cap stocks since they are widely followed and closely scrutinized.

That is in large part due to the rising popularity of algorithmic trading, which requires a constant flow of data to compare a stock to its peers. But small-cap stocks are less accurately measured by those same data points, and in most cases have few if any direct competitors against which to be measured.

That means each company must be evaluated fundamentally, which is a time-consuming process. Few Wall Street analysts are willing to spend the time necessary to fully explore all of the variables that might influence the price of a small company that is of little interest to their clients.

For that reason, occasionally a small-cap stock ends up becoming grossly undervalued. When that happens, there is an opportunity for huge gains in a relatively short period. All it takes to catapult the stock higher is a single event or news story that suddenly puts it in the media spotlight.

What all of that means is that investors usually don’t notice bad news about small companies, but they do hear the news when it is good. And with headline risk, well, back in the headlines, this may be a good time to swap out some of those overpriced large-cap stocks you own for a handful of small companies on the verge of a breakout.

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