Index Roulette Vs. Individual Stock Potential

by: Joseph Allen

The major indices, although interesting, frequently do not tell a story that is useful. That is because they are too broad - they cover too many shares that together are worth too much money to be representative of any individual issuer. In other words, the fact that the Dow Industrials are at an all-time high or that the S&P closed Friday at a new high, with the Nasdaq Composite at a 13-year high, would not be a hint that Intel (NASDAQ:INTC) was down over 5% on the day on Friday, or that Akamai (NASDAQ:AKAM) has taken a nearly 20% dive since October 22.

As a historical measure, the major indices may be helpful in deciding whether the overall market is generating profits for investors as a group, and the individual chartline of each index may be a valuable indicator of which group has made the best (or worst) returns over a period of time, as long as we understand that statistics always look backward, not forward. We have to keep in mind that the indices by their nature "dumb down" the process of picking individual stocks, and frequently flatten the returns by mixing winners and losers. For some people that is the essence of portfolio diversification, but of course it is someone else's portfolio unless you are investing in indexed funds that hew to the index weighting pretty closely.

Having said all that by way of warning, if you look at the performance of four of the most commonly consulted indices, it is interesting how the indices rank with regard to return vis-à-vis the way the media covers the companies that comprise them.

"How's the market?" If you call a broker and ask that question, the answer is likely to be a quick answer that is simply the current change of the Dow Industrial Average. So at the moment as I write, the answer would be "The market is up 54.78," meaning the Dow Industrial Average is up 54.78. If you watch the evening news or look at the business section of the digital version of the NEW YORK TIMES, you will get the current price of three indices: the Dow Industrials (NYSEARCA:DIA), Nasdaq Composite (NASDAQ:QQQ), and the S&P 500 (NYSEARCA:SPY). Those are probably the best-known indices, although the Dow Transports have their adherents too, especially in the crystal-ball department.

Interestingly the Dow Industrials, whose recent surge past 16,000 has been headline news, has underperformed on a percentage gain basis this year not only Nasdaq and the S&P 500, but also the Russell 2000, which is generally thought to be a good index for small-cap and some mid-cap companies. That is true right now whether you look back 90 days, 180 days or a full year. You can construct a comparison chart yourself by going to Yahoo Finance and getting a chart on the Russell 2000 and then pressing the "Compare" button and adding the Dow Industrials, Nasdaq Composite and S&P 500 indices to the chart. The chart will show the percentage gain of each of the indices. All four indices are up nicely in any of those periods, and many of the dips and gains are reflected on a daily or weekly basis in all four, showing that market jitters or ebullience does tend to raise or lower all boats in some ways.

Of the four indices, there is a seesaw between Nasdaq and the Russell 2000, with one or the other being on top percentage-gain-wise, depending on the time period. For the full-year lookback, the Russell 2000 is firmly in the lead. On a six-month lookback, Nasdaq is ahead by a nose, and on a 90-day lookback, Nasdaq is ahead by a bit more than a nose, but not by as much as the Russell is ahead for the trailing 12.

This is interesting because we've been hearing for quite a while that (1) this leg of the bull market would bring the biggest returns on small-cap companies, and at the same time (2) the market is still investing in "quality," and the small caps continue to languish.

Both are true, of course. There are so many small caps that the vast majority of them are going begging even as the broad market hits new highs. The ones that are picked up by the media, or, to some extent, by the sellside, trade better, and that can allow institutional investors to buy in without sending the prices skyrocketing. Some small companies make more effort to be noticed by investors, using communication tools and investor relations experts to explain their strategies and opportunities, while others follow the "if you build it they will come" train of thought, which is the same as the old "better mousetrap" theory. In my view, neither of them works. Even the most remarkable person, the most physically handsome, the tallest, strongest, smartest, best educated runs the risk of not being noticed while running a marathon race with 10,000 other runners - perhaps not an apt analogy to the position of a small company in the stock market, but close enough for government work.

The general belief is that the smaller the company, the more fragile it is, and the more susceptible to unfortunate events. The balance is that the smaller the company, the more able it is to double, triple, quadruple in size and profitability, possibly leading to a fast rise in value if it is noticed and traded. I read recently about what a small investment at the earliest possible time in Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG), Cisco (NASDAQ:CSCO), Amazon (NASDAQ:AMZN) and some other companies would be worth today, and the percentage gains are astronomical. I recall that a $100 investment in one or more of them when they went public would be worth $40,000 today. That's because they were small and are now large - and that growth has happened over a fairly short period of time, far less than the average work life of an American living now.

The takeaway from that is that if you invest in Exxon Mobil (NYSE:XOM) over a period of years, you are likely to find that your investment has appreciated over time. If you owned shares of XOM in mid-1999, you would find that your stock has appreciated about 250%, while it has also paid an average of about 2% per year in dividends, which takes it up another 30% or so pretax if you saved all that money. Not bad, better than inflation by a good bit, but not a home run. In that same time period, if you had bought Amazon, you'd be up about 370% -- better, and close to a 4-bagger. If that investment had been in Apple, you'd be up 516% or thereabouts (depending on the date you bought it) - definitely over the center-field wall with a man on base. And if you had bought Google in 2004 when it went public you would be up 923%, which is definitely a Grand Slam and then some. And had you invested in Cisco, you would be at about a 33% loss right now.

Of those XOM is a longtime blue chip, one of the world's biggest and foremost industrial companies. Apple was at a very low point in 1999, but it was not a new company by any means, having been a publicly-traded company for 18 years by then. Cisco was less than 10 years old as a public company, but on its way to a bubble top - still a good company, but timing would have been everything with Cisco, and the period 1999 to now would have been, well, unfortunate. Amazon was between a year and a year-and-a-half old when you bought it in 1999, and Google's IPO was in 2004. That group of companies was chosen more or less at random and for no particular reason, and it is far too small to draw any conclusions from, but it does show that a smaller company can deliver a larger return than an established industrial if all goes well. I always remember my grandfather telling me that blue chips were not infallible investments, pointing out that when he was my age (I was a teenager), Pullman was a blue chip, and Pullman's market evaporated like a rain puddle on a hot day when air travel became common, and that was before I was born.

Investing in blue-chip or "quality" companies is no guarantee of success, even though XOM was up nicely in the time period above. In that same time period, an investment in Dow Chemical (NYSE:DOW) would be flat to a slight loss; an investment in General Electric (NYSE:GE) would have gone from the mid-40s then to 27 today; an investment in British Petroleum (NYSE:BP) would have gone from the mid-50s to 48; and an investment in JPMorgan Chase (NYSE:JPM) would be up about 10%, not keeping up with even the low inflation we have had over that time period. And if those are not blue-chip "quality" companies, nothing is.

I'm not arguing against portfolio diversification and certainly not looking down my nose at blue chips; investing is not like playing roulette and no one should put all their chips on a high-risk investment. And of course the prairie is littered with the bleached bones of small companies that either stayed small or went poof, and dart-board investing with small caps is considerably more dangerous to capital than playing wheel of fortune in a Las Vegas casino.

There are a lot more small public companies today than there were in 1999, and there are a lot of entirely new types of companies. New media, social media, personalized medicine, electric vehicles, smart-grid companies, cloud computing and SaaS companies, big renewable energy electric generation companies, to name just a few.

Smaller companies have the potential to make a portfolio grow, and, although the failure rate among small companies is inevitably many times higher than among larger companies, the initial investment may be much smaller as well. After all, the odds against a 10-bagger when you pay $2 or $20 a share for the stock in the first place are much better than if you pay $200 a share to start. The performance of the Russell 2000 is helpful, but the companies included in the Russell 2000 may be more fully valued than other similar companies, because inclusion in the Russell 2000 means that all indexed funds who use the Russell 2000 will buy a company's stock to some extent - so their trading liquidity frequently improves greatly upon inclusion.

Not everyone's investment goals are the same. For people looking for income, many small caps are out of bounds. Not that there aren't some great yields if you can tolerate a higher degree of risk. There are numerous marine transport companies, for instance, with handsome yields, and given financing trends over the last several years, there are also REITs and numerous growing smallcaps with junk-bond yields on an alphabet soup of preferred stocks. Of course with a smallcap you may end up with dividends paid in stock, but cool it - the advantage there is that you may not have to pay taxes, at least not right away. Set your filters for yields in stocks selling for under $15, and see what you get. You might find REITs like STAG Industrial (NYSE:STAG), yielding over 5%; Sabra Healthcare REIT, also yielding over 5%, Senior Housing Properties Trust (NYSE:SNH), yielding over 6%; Healthcare Trust of America (NYSE:HTA) with a yield in the mid-5's; or Summit Hotel Properties (NYSE:INN) yielding around 5%. You might find shippers like Seaspan (NYSE:SSW) with a yield in the mid-5's; or a hybrid shipping finance company like TAL International (NYSE:TAL), with a yield in the mid-5's. That is a non-scientific grouping, but you can find small caps yielding over 5% easily, when treasuries are yielding next to nothing.

And you can find small caps with intellectual property that fairly clearly has an opportunity - not a slamdunk, but an opportunity - to take a commanding position in a niche that is currently not dominated by anyone. Look at QRxPharma (OTCPK:QRXPY), which apparently has a double-opioid painkiller, with at least one version that is virtually impossible to abuse as a street drug (unlike oxycodone, for instance, which is the drug of choice of hundreds of thousands of addicts). When the FDA approves the various formulations of MoxDuo®, we may see not only an improvement in the relief of intractable pain, but a noticeable diminution in the availability of such drugs on street corners. Or look at Streamline Health Systems (NASDAQ:STRM), a healthcare IT company that has gone from $1.45 two years ago to $6.75 on Friday. One thing you can trust is that small companies are originating most of the advances in IP at any given point, but especially after a recession when the best and the brightest disappeared into their garages and started a whole generation of new technology companies. After 1999 we got some of the most exciting technology companies ever - look at Google, Facebook (NASDAQ:FB) and Twitter (NYSE:TWTR), for instance.

The task of listing out smallcap technology companies with potentially disruptive products is far too extensive to try to cover in this article, which has already gone on too long. But with the assistance of your research resources, a couple of good news aggregators, and a sharp eye on top advances and declines, it is not impossible to find some strong contenders for the next generation of tech winners. The only thing for sure about tech innovation is it almost never originates in hidebound companies that are already trading at multi-billion-dollar market caps.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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