Investors seeking new ways to capitalize on an upturn in the market may be tempted to throw their weight behind small-cap shares, which have recently outpaced the broader market.
But before you jump in expecting to find bargain prices you’d better take a closer look at a few small cap quotes: Small-cap stocks are expensive compared with their large-cap peers.
The Russell 2000, an index comprising about 2,000 companies each valued at up to $2 billion, is currently trading around 20% above the last 10 year average. The ascent into bull-market territory has come after a sudden splurge of small cap buying by smaller investors
The Russell 2000 rose 15% last year compared with an 11% increase in the S&P 500. Add to that the market has seen some pretty gut wrenching falls, the Russell 2000 dropped 6.2% last November due to the uncertainty surrounding Greece and worries that a euro-zone bailout plan might fail.
Even so, the small-cap index is trading at nearly 15 times one-year forward earnings forecasts, according to Credit Suisse. That price-to-earnings ratio is about 1.17 times the P/E of the 1,000 biggest companies. This means it’s more than likely we’ll see significant volatility in the market in the near term, but the long term outlook remains strong.
Are Small Caps Still a Good Bet?
Despite the unease over Europe, many investors still expect the broader market to continue its rise well into 2013. The U.S. economy appears to be avoiding another recession and corporate earnings remain strong. Small-cap stocks are unlikely to be left out of any subsequent rally, but they are particularly vulnerable to jitters because they’re considered to be a riskier investment and tend to be more thinly traded than large-cap stocks.
Classic yardsticks still suggest that small-cap stocks could be a good bet, even if they don’t outperform the market as a whole. The Russell 2000’s forward earnings figure of 14.75 is a few notches below the historical average of 15.37. For some small-cap investors, that in itself is a powerful argument.
If the recent rally turns into a sustainable upturn through the end of the year, small-caps could continue to outperform the market. For one thing, small-caps are closely tied to the domestic economy.
What’s The Safest Way to Trade Small Caps?
So how do you get in on the action? Small caps are notorious for not having adequate financials and are not typically covered by analysts, so that means you have to trawl through thousands of company earnings reports before you find a suitable candidate.
Fortunately there’s an easier way, small cap mutual funds; by investing in a small cap mutual fund you’re getting the best of both worlds, since analyst has hopefully already done the ground work for you, saving you a lot of trouble.
Now you can safely invest in the small cap market and benefit from all that it has to offer. Remember though that small caps are more volatile than large caps and small cap funds are not immune to this volatility. So be sure you’re ready for the ride.
Small caps should definitely be a part of a properly diversified portfolio, never be tempted to bet the house on them though. I’d limit your exposure to no more than 10% of your available capital. Small cap funds are just too volatile and can often fall as much as 40% in a single year, so be sure you’re ready for a rough ride.
If you want to learn more about trading small caps and small cap funds, sign-up for an account over at OptionsHouse, here you’ll find some useful training resources and an excellent range of tools to narrow down your search for the best performing small cap stocks and ETFs.