Returns For Less Risk

Where To Find Better Returns For Less Risk – Small Caps FTW

The whole point of investing is to make money.

But making money involves risk. And that scares away a lot of would-be investors.

Q1 hedge fund letters, conference, scoops etc, Also read Lear Capital: Financial Products You Should Avoid?

That’s because there’s no such thing as a truly risk-free investment. Not a government-issued bond, cash in your hand, or gold in your safe. Interest rates can rise and destroy your bond returns… the value of cash can be inflated away… and gold prices can fluctuate dramatically.

And stocks involve a lot more risk… management, competition, regulations, economic environment, politics… a lot can go wrong when you invest in a stock.  And you’d better get used to volatility.

Still, by default we’re naturally wired to be risk averse. And the fear of losing money is greater than the thought of making money.

That’s why many investors play it safe…

Blue chips feel safer

In the stock market, this risk aversion mentality manifests itself in investors’ tendency to stick to proven blue chip stocks – large capitalisation companies that (for the most part) have been around for decades.

Whether you’re investing through a retirement account or trading on your own, the biggest allocation of your stock investment portfolio will likely be these kinds of companies.

It’s why exchange-traded funds (ETFs) that track large-cap indexes, like the SPDR S&P 500 ETF (NYSE Arca Exchange; ticker: SPY), are so popular among investors. It’s the largest ETF, with US$267 billion in assets.

And for good reason. The index this ETF tracks, the S&P 500, consists of the 500 biggest, most-established companies listed on the New York Stock Exchange and NASDAQ. They have a long track record, are generally well diversified, have lower credit risk, and the shares are liquid. The smallest of them has a market capitalisation of just over US$6 billion.

By contrast, the S&P SmallCap 600 Index is composed of small-cap U.S. stocks with market capitalisations ranging from US$400 million to US$1.8 billion. With a median market cap of just US$1.1 billion, this index represents just 3 percent of the total market. It also represents a basket of companies deemed to carry much higher risk than blue chip stocks. Many companies in the S&P SmallCap 600 are unprofitable.

But small caps deliver bigger gains

Based on our analysis, the S&P 500 has delivered lower total gains – averaging nearly half the gains of the S&P SmallCap 600 over a number of periods.

For example, over the last 12 months, the S&P SmallCap 600 delivered a total gain of 20.7 percent compared with only 12.8 percent for the S&P 500.

Over the past five years, the S&P SmallCap 600 beat out the S&P 500 with an 81.9 percent total gain versus 66.9 percent.

Returns For Less Risk

The explanation for this is simple. Small-cap stocks tend to outperform blue chips over time because small caps have more room to grow compared to more mature companies.

After all, it’s easier for a US$400 million company to double in value than it is for a US$50 billion behemoth like General Motors to grow to US$100 billion.

The same can be seen in other developed markets such as Japan and Europe…

Over the last five years, Europe’s FTSE SmallCap Index delivered a total return of 51.1 percent. That was more than double the return of the bellwether FTSE 100 Index. The same is true for Japan, where small caps trounced the large caps, 78.5 percent to 41.2 percent, over the same period.

Returns For Less Risk

But these bigger gains come with more risk. On top of management, credit, political, and liquidity risks, small cap stocks also tend to be more volatile than blue chip companies.

Sure, you could make 60 percent to 70 percent higher returns, but you also stand a much higher chance of losing your entire investment. This scares most investors away from owning small caps.

But what if you could find stocks with high returns – for less risk?

Chinese blue-chips outperform small caps

The Hong Kong Stock Exchange and the Chinese stock markets in Shenzhen and Shanghai are three of the world’s 10 largest stock exchanges.

Their combined market capitalisations at the end of 2017 amounted to US$13 trillion, making them larger than the NASDAQ, currently the world’s second-largest exchange.

In these markets, blue chip stocks have shown remarkable outperformance of their small-cap peers, particularly over the longer term.

Returns For Less Risk

Investing US$10,000 in the blue-chip Hang Seng Index five years ago would have netted you US$4,684 in profits, while the same investment in the much risker Hang Seng Small Cap Index would have only given you back US$1,112 in gains. That’s a 4-to-1 ratio in terms of total returns.

So why is it far more rewarding to invest in safe blue chips instead of riskier small caps in Hong Kong and China, relative to Western markets?

A lot of it has to do with the risk-reward payoff. Or essentially, what returns you expect to get for the amount of risk you’re taking on.

In China, small caps are growing slower

To explain this, let’s go back to the U.S. market for a minute. There, the S&P 500 is trading at a 20.8 times P/E multiple. It’s yielding 1.91 percent, and it’s expected to grow profits by 13 percent annually over the next three to five years.

Meanwhile, the S&P Smallcap 600 is trading at nearly 22 times P/E, yielding 1.36 percent, and profits are expected to grow 12.8 percent annually.

Given similar P/E ratios and expected growth in corporate earnings, as well as the difference in yields, investing in the S&P 500 has a better risk-reward profile than its small cap counterpart. But as I showed you earlier, you likely won’t see as big of gains from investing in the S&P 500.

But over in Hong Kong and China, the risk-reward payoff is skewed very much in favour of the larger cap companies.

The Hang Seng Index, for example, trades at just 12.2 times P/E. It’s yielding 5.25 percent, and profits are growing 17.1 percent annually, according to Bloomberg.

Its small cap counterpart, the Hang Seng SmallCap Index, trades at 13 times P/E. It’s yielding 2.9 percent, and profits there are expected to grow 16.4 percent next year.

If I can get 17.1 percent annual growth and almost double the dividends investing in safe, well-established, large-cap stocks, why would I consider buying much riskier small cap stocks? It’s a no-brainer.

With China’s biggest companies experiencing breakneck growth (thanks to China’s booming middle class), it’s easy to see why they’re capable of delivering higher returns than smaller, less well-established and riskier businesses, as well as large-cap stocks in developed countries like the U.S.

This is why we’ve been urging you to overcome your home-country bias and explore investments in other markets, including buying Chinese A shares.

Good investing,

Brian Tycangco

Editor, Stansberry Churchouse Research

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