Financial Literacy

“White Cap” Stocks: Understanding The “Small Firm” Effect

“White Cap” Stocks: Understanding The “Small Firm” Effect

by Dr. Scott Brown, Advisory Panelist
Monday, August 31, 2009: Issue #1080

For decades, economists and academics have tried to define exactly how the stock market works – and the best way to profit from its moves.

In the 1950s, one argument stated that short-term market activity results in the law of one price – i.e., that buying and selling mispriced shares of the same stock forces a single price to dominate.

Then came the “modern portfolio theory,” which claimed that investors simply couldn’t beat the market averages. This so-called “market efficiency theory” was the impetus behind the formation of the Vanguard 500 Index Fund (NYSE: VFINX) – the world’s largest mutual fund.

Score one for the stuffy “efficiency theorists.”

But while they congratulated each other over brandy and cigars, a little-known professor spoiled the party in the 1980s with a straightforward study that is still the driving force behind one of the most lucrative wealth-building approaches today…

Forget “Market Efficiency”… Here’s the “Small Firm” Effect

The study simply categorized companies by market capitalization (shares outstanding times share price). The 10 divisions ranged from small to large – and research proved that small firms consistently outperformed their larger cousins for many decades.

And it’s now widely accepted that this “small firm effect” is arguably the best way for investors to beat the market.

And the logic in seeking out small firms is sound. After all, Microsoft (Nasdaq: MSFT), Wal-Mart (NYSE: WMT) and hundreds of other mega-companies all started as small firms.

It’s what we like to call the “white cap” effect…

Five Common Characteristics of “White Cap” Stocks

The beauty of “white cap” stocks is that they feature a powerful, earnings-boosting blend of three “market efficiency” anomalies – momentum, value and IPOs.

  • White Cap Stock Factor #1: Products That Satisfy Unmet Market Need

One of the key traits of a good momentum stock is that the company has an exciting new product(s) that fulfills an unmet consumer need.

Take Apple (Nasdaq: AAPL), for example. With consumers across the world clamoring for Apple products, the stock has refuted the “market efficiency” approach and delivered outstanding returns for investors.

Target very small firms with products that supply an unmet market worth at least $1 billion.

  • White Cap Stock Factor #2: Company is a Stock Market Newcomer

Many investors shy away from Initial Public Offerings (IPOs) because they’re too unknown and unproven in the stock market.

But invest properly and the risk is certainly worth the reward. Plus, you can mitigate risk by only picking small firms that have received an upgrade from an over-the-counter (OTC) stock to a major exchange. It also ensures that you’re not buying into a penny stock, which really ratchets up the risk.

  • White Cap Stock Factor #3: Low Debt

When people and institutions buy bonds from a publicly traded firm, that money has to be paid back plus interest.

This is why bondholders (debt) can sometimes hurt regular shareholders. Debt puts a drain on building assets like cash, and as debt rises, shareholder value drops.

  • White Cap Stock Factor #4: Low Competition and High Barriers to Entry

Warren Buffett, the greatest stock investor in the world, looks for companies in industries with high-entry barriers and low-exit barriers. Why? Because it’s difficult for any serious competition to join the industry.

The wisdom behind this approach is that poorly managed, unprofitable firms can get out easily without resorting to desperate price gouging – something that would cause a consumer bidding war and damage the well-managed firm’s profitability.

  • White Cap Stock Factor #5: No Analyst Coverage

Watch shows like “Mad Money” on CNBC and you get a sense that Wall Street’s attitude is, “If the public wants stocks, we’ll give ’em stocks.”

Thing is, though, lots of companies aren’t recommended to make you wealthy… but to fatten up commissions for Wall Street firms.

In fact, there are numerous studies that show that Wall Street analysts are absolutely untrustworthy. For example…

  • They’re perpetually bullish and are pressured by CEOs, fund managers and supervisors not to downgrade a stock. This means the public is almost never told when they should really sell a stock. The reality is that when there’s a fire in the house, Wall Street opens the exits for its “good ol’ boys” first and leaves you behind to get burned.
  • They often recommend the same stock as other prominent analysts. So if he’s following her, and she’s following him, just who the heck is doing any meaningful “research” on Wall Street?!
  • They’ve been caught “front-running” – i.e., recommending stocks that prominent investors, investment houses and employee option-vested Wall Street executives are trying to sell for an obscene profit. This was particularly true in 1999 and 2000, where the vast majority of top executives cashed out, even while analysts where overwhelmingly bullish across the board.

It all starts with education,

Dr. Scott Brown

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