Small-Cap Supernova

Why Warren Buffett Envies You

Written by Jimmy Mengel
Posted May 24, 2013

Pop quiz, hotshot: See if you can identify any of these high-flying ticker symbols (no cheating!)

  1. PCYC

  2. ALK

  3. TWO

  4. GPOR

  5. OCN

The answers are below the fold...

Drum roll, please...

Here are the answers: 

  1. PHARMACYCLICS, INC. (NASDAQ: PCYC)

  2. ALASKA AIR GROUP, INC. (NYSE: ALK)

  3. TWO HARBORS INVESTMENT CORP. (NYSE: TWO)

  4. GULFPORT ENERGY CORP. (NASDAQ: GPOR)

  5. OCWEN FINANCIAL CORP. (NYSE: OCN)

So how'd you do? If you got more than one, give yourself a pat on the back... You've outscored your humbled editor.

These five companies are the top holdings of the Russell 2000 Index, the leading indicator of small-cap U.S. equity performance.

And while the press was crowing about all-time highs in the DOW and S&P, the Russell 2000 quietly hit a record of its own: an all-time high of 1,000 this week, just as the other indices pulled back.

The Russell 2000 is a collection of the bottom 2,000 companies in the Russell 3000 — which make up a mere 8% of the total market cap for that index. In other words, these companies are small, with the average market cap around $1.26 billion, compared to the S&P, which requires a market cap of $4 billion to even qualify.

The bulk of the Russell's holdings are in Financial Services, Consumer Discretionary, Producer Durables, Technology, and Health Care. 

The index is a good measure of how small domestic stocks are doing. Because most of the index is comprised of U.S.-based stocks, they have less exposure to Europe's economic woes, which could bode well for the rest of 2013...

These wild child small-caps have actually outperformed their stable big brothers over the past year:

^RUT Chart

From June 25, 2012, to May 3, 2013, consumer discretionary stocks led the pack, yielding an impressive 33.6% as consumers kept on spending.

These sectors followed with great yields as well:

● Russell 200 Materials & Processing Sector – 31.1%

● Russell 2000 Energy Sector – 28.1%

● Russell 2000 Producer Durables Sector – 27.9%

● Russell 2000 Financial Services Sector – 26.6%

If you don't trust yourself to weed through the oft volatile small-cap sector, you can easily play the iShares Russell 2000 Index Fund (NYSE: IWM), which is already up 15% this year. Had you bought and held since the start of the year, you would have out-performed most big-shot fund managers.

If you want to further mitigate your risk, you can opt for the SPDR Russell 2000 Low Volatility ETF (NYSE: SMLV). This fund was launched in February and tracks 164 low-volatility small caps, with heavy exposure to Financial, Utilities, and Industrials.

But if you're swinging for the fences (as we like to do when we get a good pitch to hit), small-caps are perhaps the one area of the market where individual investors like you and I actually have an advantage over the bigwigs. In fact, Warren Buffett himself once said he envied folks like us — individual investors with less money to spend but more flexibility on where to spend it.

Why, you ask? Because size does matter...

At a shareholders meeting years ago, Buffett claimed he could generate 50% returns regularly, if only he had less money...

How? By investing in small-caps that have potential to double — or even triple — in value, and far quicker than the “value” stocks Uncle Warren is famous for.

The problem for Buffett is that even if he bought into a small-cap that exploded, the company's market cap wouldn't be enough to even move the needle on Berkshire Hathaway's portfolio.

Say Buffett bought 'Company X' with a market cap of $300 million, and it doubled... that would only boost Berkshire's bottom line by a measly 0.7%. Hardly worth the research and risk. But if you or I doubled our money in a small-cap like that, we'd be riding high on the hog. 

And as we saw with the quiz, you'd be hard-pressed to find too many investors who even recognize many of the names on the Russell 2000, much less have to wherewithal to play them successfully.

And that's the way we like it. It allows us to compete with the Insiders.

That's what Outsider Club is all about: positioning you to profit outside of the mainstream news buzz and billionaire shareholder reports.

We go through an exhaustive vetting process in order to give our readers the biggest gains possible with the least amount of risk.

And we've got our eyes trained on the next small-cap sector boom: biotech.

My colleague Nick Hodge has discovered a company that just secured a patent to a technology that will forever alter the way the medical world operates.

It won't be long before this story hits the pages of the Wall Street Journal and Barron's... and by then, you'll have missed the boat. Stay tuned for that report...

Godspeed,

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