Why Traders Ignore the Small Stocks With the Best Potential
- Inexperienced traders often go after the biggest stocks – Apple, Amazon, etc.
- But, as Alexander Green explains, they are missing out on major profit potential by ignoring the small stocks – more specifically, microcaps.
Thanks in part to the coronavirus, more than 500 companies have filed for bankruptcy this year.
The biggest by far is Hertz (NYSE: HTZ), which sought Chapter 11 protection in May with $25.8 billion in assets and $24.4 billion in liabilities.
Some companies restructure and survive bankruptcy. Many do not.
The ones that don’t generally go into liquidation. In a liquidation, shareholders don’t receive a dime until bondholders, creditors and other lien holders are paid in full.
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In other words, they usually get nada.
So sophisticated short-term traders generally avoid bankrupt companies.
Yet in the last month, traders have flocked to Hertz. From a low of $0.40 on May 26, they bid it all the way up to $6.25 on June 8.
That’s a great return for someone who got in a month ago and sold a couple weeks later.
Of course, going to a casino and putting all your money on a number at the roulette wheel can pay a great return too. But I don’t recommend it.
As I write, Hertz has succumbed to gravity and reality. The stock is back near a dollar.
What were those traders thinking? The evidence suggests they were not.
Many low-priced stocks are being manipulated by hordes of inexperienced day traders, most of them millennials and Gen Xers. Stuck at home during the pandemic with no professional sports to bet on, they have turned to the stock market.
Instead of riches, most will receive an education that makes the Ivy League look cheap.
Jaime Rogozinski, founder of WallStreetBets, heads such a group with approximately 1.3 million members. And he has no illusions about their investment prowess.
“They don’t know what they’re doing. And they don’t care that they don’t know what they’re doing,” he says. “To them, there’s no sense in looking at a company’s balance sheet or figuring out how to do a discounted cash-flow analysis. They just regard the volatility as an opportunity for fun.”
The sad part is these traders’ instincts are basically correct. Low-priced stocks do offer the biggest potential returns.
(Although you won’t earn them flipping shares every few hours… or minutes.)
Run your finger down the list of the best-performing stocks each year and you’ll find that the vast majority of them – if not all of them – are microcaps.
Microcaps are small companies with a total market capitalization – calculated by multiplying the stock price by the number of shares outstanding – of well under $1 billion.
I’m not talking about worthless (and easily manipulated) penny stocks, zombie firms or companies struggling through bankruptcy.
I’m talking about real companies – with real products and services and rising sales and earnings – that are early in a high-growth phase.
These have the potential to generate some of the market’s biggest returns. It’s not hard to see why.
They are tiny, so mutual funds and hedge funds can’t buy them. Wall Street doesn’t follow them. And the mainstream media doesn’t report on them.
This information vacuum creates vast opportunities for those willing to do a bit of due diligence.
For instance, here are the two-year returns through January 2020 for the five top-performing stocks in the S&P 500:
- Fortinet (Nasdaq: FTNT): 82%
- MSCI (NYSE: MSCI): 83%
- Paycom Software (NYSE: PAYC): 101%
- Chipotle Mexican Grill (NYSE: CMG): 101%
- Advanced Micro Devices (Nasdaq: AMD): 354%.
Not bad. But compare those returns – the best of the best – with the top-performing microcaps over the same period:
- Paysign Inc. (Nasdaq: PAYS): 1,185%
- Relmada Therapeutics (Nasdaq: RLMD): 1,464%
- Emisphere Technologies (OTC: EMIS): 2,544%
- Fastbase Inc. (OTC: FBSE): 3,483%
- Nocera Inc. (OTC: NCRA): 7,799%
Investors everywhere want to earn higher returns. But many are going about it the wrong way.
No, they are not gambling like the testosterone-fueled day traders. They make the opposite mistake. They look exclusively at huge companies that should give decent returns in the weeks and months ahead, but almost certainly will not generate extraordinary returns.
Take Apple (Nasdaq: AAPL), for example.
It’s a fine company. I’ve owned shares of it for over 25 years now. The annual dividend is many times my original investment.
But today it has a market cap of $1.5 trillion. It will not become a $3 trillion company anytime soon.
I bought Apple when it was a small company. Now it is the world’s largest.
Personally, I’m much more interested in finding the next Apple than arguing about whether that company is a “Buy” or “Hold” today.
There are plenty of publicly traded companies out there with the potential to rise severalfold in the months and years ahead.
But they tend to be microcaps, not megacaps.
If you’re not earning the outsized returns you’d like, don’t focus entirely on large firms. And don’t waste a minute on little ones without stellar fundamentals.
Instead, devote a portion of your portfolio to fast-growing small companies with successful products and services – and superb prospects.
If you’re going to cast a line, that’s the pond where you want to fish.
About Alexander Green
An expert on momentum investing, value investing and investing based on insider activity, Alex worked as an investment advisor, research analyst and portfolio manager on Wall Street for 16 years. He now runs the wildly successful Oxford Communiqué, ranked as one of the top investment newsletters by Hulbert Digest for more than a decade. He is also the author of four national best-sellers: The Gone Fishin’ Portfolio, The Secret of Shelter Island, Beyond Wealth and An Embarrassment of Riches. He shares his wisdom in his free daily e-letter, Liberty Through Wealth.