Today I’m bringing you the second part of my question and answer session with Cabot Small-Cap Confidential Editor Thomas Garrity. Tom reveals his current small-cap stock outlook, what he learned in 2008 and 2009 and his top sectors right now. Enjoy!
(You can read the first part of the series here.)
Question: What is your current outlook on small-cap stocks?
Answer: Historically, small-cap stocks are the last asset class to emerge from a recession. By this time, many large-cap stocks have already enjoyed their day in the sun as big institutional investors in search of refuge from a faltering economy seek them out for stability. This means that small-cap stocks, even with their high upside potential, will have largely been neglected.
But this is actually a good thing for individual investors. As institutions largely ignore small-cap stocks, smaller investors can often buy them for a reasonable price. Valuation is just one reason why these stocks are so attractive. The other major reason is growth potential.
You might be wondering where earnings growth is going to come from if the economy is still not recovered, as I mentioned last week. Small companies breed innovation, which is at the heart of product differentiation. As companies decide how best to maximize what little capital resources they have, it is their products that will be seen as having rapid payback, providing opportunities to gain market share and allowing them to enter fresh markets.
Companies that want to gain a competitive lead are likely to make investments in cutting edge technologies. It goes without saying that spending by companies to get ahead will be important, shifting the balance of power in the direction of smaller, more nimble organizations. In this environment, a business’s fate could be decided based upon strategic investments. Products with mass appeal are the trademarks of successful small-cap companies.
These market dynamics bode well for small-cap stocks in both the near and long term. Over time, small-caps have been the best place to invest your money as an investor in individual stocks. They are exceptional builders of wealth, something to consider when building your portfolio. From a broader perspective, as more investors become aware of this high-potential asset class, there’s a good chance they will invest in small-cap stocks, thus further enhancing their returns.
Question: What did you learn from the 2008 bear market and 2009 recovery?
Answer: The bear market reminds me that when the financial markets are deteriorating, investors could even ignore companies with strong balance sheets and healthy growth prospects. When the market is challenging, it’s tough to get investors interested in even the best stocks, which is needed to push them higher. Therefore, I recommend raising cash when the market is weak and investing again once the market is healthy.
The recovery of the last year has also been instructive. And the recent correction reminds me that stocks won’t go up forever. Financial stocks have been a favorite investor holding during the recovery, primarily due to the government aid that banks received. This has resulted in massive price swings in these stocks, especially now as big investors seek to unwind their positions and look for more stable investments.
These relatively short-term swings demonstrate that many investors are holding stocks for shorter periods of time right now. As I’ve often said, “You don’t have a profit until you sell.” In light of this, I’ll be advising investors to take profits sooner rather than later.
Question: What sectors are you interested in right now? Why?
Answer: I’ve always been interested in technology and medical stocks and more recently, I’ve been increasingly drawn to alternative energy stocks. Technology stocks have historically had little trouble drawing investors to them, probably because they have a high potential for appreciation. It can be tedious to wait for investors to recognize the value of a technology stock, but once they do, these investments can be very profitable.
If you look at great companies, like Apple and Cisco, you’ll see that each started out very small. What enabled them to grow by great leaps and bounds was their inventiveness and vision. In some cases, they designed their products ahead of actual customer demand, defining an industry niche by the time people caught on.
That’s the beauty of a small-cap investment; there’s a great deal of patience involved waiting for the stocks to appreciate, but when they do, the rewards can be enormous. Putting aside economic woes, technology companies and their products will almost always be in demand, since change is what brings about growth in the overall economy.
Like technology stocks, medical stocks offer the possibility for unusually large upside potential. The same opportunistic characteristics apply, the only difference is that the medical sector is subject to regulation.
But the sector I’m most excited about right now is alternative energy. This sector can include such diverse areas as electric vehicles, efficient building materials and lighting and bio-fuels derived from waste. The bottom line here is that these industries are tapping into areas that we as a society need to engage in. They are creating jobs, lowering energy costs and lessening pollution. As an example, building an electric vehicle plant creates jobs, reduces dependence on oil and improves air quality.
Question: What else you would like to say to subscribers regarding small-cap stocks?
Answer: We hit some home runs last year and we still have many stocks in the Cabot Small-Cap Confidential portfolio with compelling stories that will eventually be discovered by large institutional investors. As always, my efforts this year will be research driven as I look for stocks that can become market leaders with large addressable markets.
I’m constantly refining my investing strategy and in this vein, I’ve been advising investors to lock in profits by taking small portions of positions off the table as stocks climb higher. However, I still advise keeping a core holding if the stock looks like it has farther to run. In addition, booking some gains frees up cash to open other positions in new stocks. In closing, I’m very thankful for our subscribers and will continue to work to retain their trust and pick the very best small-cap stocks.