Get Rich Quicker with Emerging Small Caps

10/20/2009 1:00 pm EST

Focus: ETFS

Nicholas Vardy

Editor, Bull Market Alert, The Alpha Investor Letter, and The Global Guru

Nicholas Vardy, editor of The Global Guru, says emerging market small-cap stocks have the best returns with similar risk as their large counterparts.

The single best way you can get rich is to invest in a portfolio of highly volatile, small-cap stocks.  Some stocks will tank. Others will soar. But over time, the gains from your winners will make up for your losers.

Small caps are much more volatile than their large-cap counterparts. You're guaranteed a wild ride. But [they] will get you where you want to go faster than you can ever imagine.

So, if betting on small caps is your single best way to generate wealth in US markets, can you replicate this strategy in even more profitable (and volatile) global markets?

The short answer, I believe, is "yes."

When the economy turns around, small and nimble companies [usually] are able to react first. Small caps are the canary in the coal mine for economic recovery. Comparing the Standard & Poor’s 500's performance against the Russell 2000 small-cap index over the last six months confirms this.

I believe that the small-cap effect may be [even] stronger in developing global stock markets than in developed markets like the US and Japan.

First, investing in global small caps exposes you to a whole universe of stocks [that] are listed almost exclusively on their home exchanges. And the market-cap-weighted S&P Emerging SmallCap Index is concentrated heavily on consumer goods, materials, and hardware. Focusing on these sectors, you get the exposure to the fast-growing local domestic market, which you don't always get in foreign large caps.

Second, doom-and-gloom headlines notwithstanding, some global economies were not hurt as badly as others during the credit crunch, because they had little exposure to the financial crisis. Smaller companies also are more nimble and can better address changing environments quickly. So, once the global economy drew back from its precipice, small caps recovered before the large, global conglomerates. Put another way, global small caps are the untold "decoupling" story.

Third, a portfolio of small caps may be actually less risky than their large-cap counterparts. This flies in the face of conventional wisdom, which has it that small-cap emerging market companies are riskier than traditional emerging market investments.

But although an individual small cap may be much more risky because of its narrow focus, in the aggregate, you have much more diversification with a group of small-cap investments. Last year, the SPDR S&P Emerging Markets Small Cap ETF (NYSEArca: EWX) suffered a 54.62% decline.

But that was no worse than the decline in the large-cap focused iShares MSCI Emerging Markets Index (NYSE: EEM). Meanwhile, this year, the small-cap index and its related ETF have strongly outperformed the large-cap benchmark.

Finally, as a small investor, you have a huge advantage over large institutional money and hedge funds. They have issues of liquidity and the threat of huge drops in the value of their holdings to deal with. All you need is a cast iron stomach.

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