Monday, November 21, 2011
When the conditions are right, small caps give investors the best chance at generating triple-digit gains.
But the last few months have been some of the toughest conditions for small caps since 2008.
My colleague, Phase 1 editor Frank Curzio, and I have seen a lot in the small-cap universe over the past decade. In the last few months, our daily conversations have sounded more like something you'd overhear on a battlefield.
The latest news about China's economy or Europe's banks is sending small caps up or down 10% in a couple days. It doesn't matter whether a company's business has anything to do with China or Europe.
And that's why we talk about strategy now... more than ever.
During one three-month stretch this summer, more stocks in the small-cap Russell 2000 were down 50% than were in positive territory. In October, the Russell soared more than 25% in just over three weeks.
Frank and I saw these huge swings starting in July. So we made adjustments in micro-cap-focused Phase 1 Investor and Penny Stock Specialist.
The first adjustment was buying half-sized positions. We told readers that if they normally put $2,000 into a new position, they should only commit $1,000 at the start. Buying a half-sized position leaves investors with room to add the second half at a much better price if the market makes a big move lower over the following weeks.
We've used this strategy frequently this summer and fall. And we've secured 5%-10% "discounts" on our picks. More than once, that's pushed what might have been a losing position into breakeven or profitable territory.
The second strategy change is taking profits sooner than normal. When the market is zig-zagging all over the place, a normal "buy and hold" strategy doesn't work well. If you want to improve your returns, traders have to be willing to take advantage of rallies by selling a portion of winning positions.
For example, in July we sold half a position in a small-cap silver miner that was up 30% since the original recommendation in Penny Stock Specialist. It pulled back more than 20% shortly after.
In September, we sold a half-position in a small energy stock. Shares jumped 40% in just three weeks. Penny Stock Specialist readers were sitting on a 100% gain from the original recommendation price. Just after we sold, the stock saw a nearly 30% correction.
Back in September, Frank noted that the best time to buy small-cap stocks is when the fear index – the "VIX" – is below 25. We could stay above that level for months. So we need to use the volatility to our advantage.
Two ways to do that are to "leg in" to positions, purchasing only a half or third to start, and taking some profits off the table "early." Following these two strategies will have you buying on weakness and selling on strength.
With all the volatility, these aren't the easiest conditions for small-cap investors. But they can still be plenty profitable.
Position sizing is one of the most important concepts in investing. Editor in chief Brian Hunt recently taught Daily Crux readers how to use this strategy to their advantage. "If you don't know the basics of this concept, it's unlikely you'll ever succeed in the market," Brian says. To access this – and other invaluable investing secrets – for free, sign up for The Daily Crux here.
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