The Law of Large Numbers
Tried and True Investing Rules
In Case You Missed It
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In honor of the two-year anniversary of Cabot Small-Cap Confidential, I’ve been bringing you a multi-part series with Editor Thomas Garrity. Tom has explained how he got interested in small-cap stocks and where he thinks the market is going. Today he’ll reveal some of his time-tested investing rules. I hope you enjoy it!
(This week is the last in the series. You can read the previous two week’s issues here http://www.cabot.net/Issues/CWA/Archives.aspx )
Question: Why do you prefer to invest in small-cap stocks? What benefits do they offer investors?
Answer: The obvious reason for investment in small- and micro-cap stocks would be that they have a proven and long history of outperforming all other asset classes. The last statistics I saw on the performance of small-cap stocks showed that during a 79-year period, small-cap and micro-cap stocks have outperformed large-cap stocks by 165% and 437% respectively.
The second reason may sound a little silly, but I’ll tell you anyway. When I was a kid my dad used to take me with him to the dump to unload unwanted junk from our station wagon. On returning from the dump, we’d have more stuff in the car than we started with! I like finding the true value of something that others have neglected and failed to correctly appraise. Small-cap stocks fit into that perfectly.
As the U.S. enters a new chapter, I believe that investments in small-cap stocks will be better positioned to deal with the economic uncertainty that lies ahead. We know now that bigger doesn’t necessarily mean better. The best investment choice is the nimble one that can adapt to change, and for this reason I feel that small-cap stocks have a distinct advantage.
Question: What sectors are you interested in right now? Why?
Answer: My models are currently favoring alternative energy, technology and health care stocks. In times like this, asset managers want to invest in trends that won’t be hot one minute and cold the next. Investors want to put their money into stocks of companies whose operations are sustainable and whose destinies aren’t going to be hung out to dry by the economy or next product cycle. Investors are looking at enterprises that are creating the new economy instead of chipping away at the old one.
I’m focusing my time and money on Green companies whose products contribute to the welfare of both people and the economy. Let’s consider an investment in a hypothetical company that manufactures process control equipment to produce cleaner forms of energy. Right out of the gate in the stock selection process, we’ll know whether the company approaches investment worthiness--the business has strong fundamentals that can be easily quantified. For instance, we know that X amount of petrol is used by vehicles of all types on the road, each of those vehicles contributes Y amount of pollutants, causing Z amount in health care costs and so on.
Here I’m only addressing a single market, alternative energy, but my approach includes many more peripheral variables that strengthen the merits of the investment theme. Call it a three for one investment approach: this company that makes the environmentally friendly fuel does a lot more than produce an ultra clean fuel product. It reduces our dependence on expensive. Diminishing resources and indirectly reduces the cost of health care and so on. So I guess you could say I’m looking at dramatic shifts in how we live our daily lives and the products and perceptions that go along with those changes. Expensive oil is taboo, as are pollution and costly health care, and the United States’ desire to remove these encumbrances is already in motion.
Similar parameters for identifying stocks are applicable to companies that produce wireless components/software, produce vaccines or manufacture medical devices. We have data that suggests there is an existing large pool of users for these products and services, that these audiences are growing based on demographics and that the products or services are making their way into our everyday lives.
In short, I’m abiding by the Law of Large Numbers and sticking with large addressable markets. I’m currently applying much of my investment analysis to the alternative energy, technology and health care sectors.
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Question: What are your tried and true investing lessons and rules?
Answer: I have a lot of investment rules, but two of the most important are: “Stick with it” and “Don’t be afraid to take profits.” As a small-cap investor, I tend to hunker down in an investment for the long term until institutional investors invest in it. I find that sometimes the waiting (which Jesse Livermore described as the way to make money) while anticipating the arrival of institutional investors can be both a little boring and thought provoking.
Let me elaborate. Small caps are thinly traded, which generally means two things: 1) Little trading activity, for the most part it’s you and a few other stock research enthusiasts holding the stock; 2) Since few trades occur in these stocks, the shares tend to trade with greater volatility than say mid- or large-cap stocks.
A lot of investors will sell out of a position because a stock is not moving favorably or quickly enough. The tragedy is that we’ve done all of the research that goes into finding a qualified investment and the moment the stock moves from its slumber past our purchase price, investors often sell out, missing out on tremendous moves in these stocks.
But I think you should stick with the investments that you’ve worked so diligently to research. Know that small-cap stocks can be finicky, but that eventually you’ll get paid--in some cases many fold--for your research work and tenacity.
When investors make big gains in their portfolios, they often don’t want to sell out their winning stocks. But not taking profits is a foolish mistake. You’ve got to pay yourself for your work. Whether you’re inherently stubborn or you’ve just acquired a taste for greed, you need to detach yourself from this dangerous trait.
The best advice I can give is, “Collect rent for time well spent.” I can’t tell you how many times I have the urge to take the multi-home run stock for just one more at bat. But taking another swing for more gains is risky business and you may well end up losing the lion’s share of your profits or worse.
Question: What else you would like to say to subscribers regarding small-cap stocks?
Answer: Small-cap stocks will continue, in my view, to be the superior investment over time. Every great company that starts out small in business and eventually flourishes to become a large company with origins in venture capital. Somewhere along the line, private investors provided the necessary funding for the company to grow. Investors will continue to pay for growth, as that’s the true spirit of investing. The markets may re-evaluate what financial metrics matter most for stock selection, but growth will always be in style.
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In case you didn’t get a chance to read all the issues of Cabot Wealth Advisory this week and want to catch up on any investing and stock tips you might have missed, I have links below to each issue.
Cabot Wealth Advisory 9/21/09 - The Great Bull Market of 2009
On Monday, Timothy Lutts wrote about 10 random thoughts on topics ranging from the possible bankrupting of the largest casino in the world to a tax on soft drinks. Tim discussed the trends that are telling him that the market is healthy and a stock that is known as the “Google of China.” Featured stock: Baidu (BIDU).
http://www.cabot.net/Issues/CWA/Archives/2009/09/Bull-Market-of-2009.aspx
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Cabot Wealth Advisory 9/22/09 - Two Very Different Stocks in the Same Industry
On Tuesday, J. Royden Ward wrote about the Cabot Wealth Advisory survey and answered some readers’ questions from it. Roy also discussed two very different stocks that are both in the same industry. Featured stocks: Bunge (BG) and J.M. Smucker (SJM).
http://www.cabot.net/Issues/CWA/Archives/2009/09/Two-Stocks-to-Consider.aspx
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Cabot Wealth Advisory 9/24/09 - The Economist Who Made Your World Better
On Thursday, Paul Goodwin wrote about an economist who changed the way the airlines do business, greatly benefiting passengers. Paul also discussed the initial public offering of Shanda Games and how to handle IPOs. Paul finished by writing about a good stock with a great name. Featured stocks: Shanda Games (GAME) and Mindray Medical (MR).
http://www.cabot.net/Issues/CWA/Archives/2009/09/Economist-World-Better.aspx
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Until next time,
Elyse Andrews
For Cabot Wealth Advisory
Editor’s Note: Don’t forget about our Limited Time Anniversary Price Rollback for Cabot Small-Cap Confidential. Subscribe by September 30 (less than a week away!) and save 30%! Click now to get started.
http://www.cabot.net/info/csc/cscji07.aspx?source=wc01
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