Investing in Breakthrough Technology: Profit With Small Caps Ahead of the Mainstream

Marc Lichtenfeld
by Marc Lichtenfeld, Chief Income Strategist

Investing in Breakthrough Technology: Profit With Small Caps Ahead of the Mainstream

by Marc Lichtenfeld, Advisory Panelist

Wednesday, May 19, 2010: Issue #1263

Mind-boggling.

That's really the only way to describe some of today's technological advances. For example...

  • Just 20 years ago, an HIV-positive diagnosis was a certified death sentence. But thanks to medical advancements, it's now a manageable disease. Even some cancers could soon become chronic conditions, not guaranteed fatalities.
  • Apple's (Nasdaq: AAPL) range of "i" products and Amazon's (Nasdaq: AMZN) Kindle have revolutionized the way we interact, do business, enjoy popular culture and accomplish tasks. Pocket-sized devices now have so much computing power even Ray Bradbury wouldn't believe it.

Investing in companies that produce breakthrough technology is a good way to generate outsized returns and accumulate wealth.

But if you find yourself watching features of these next-generation products and technologies on 60 Minutes or Nightline wondering how you can get ahead of the mainstream and profit from the buzz early, here's the trick...

Does Size Matter? Not When It Comes to Small Caps...

Most of the time, the companies profiled are the bigger, more familiar firms. But while they grab the headlines, the smaller, under-the-radar outfits are also responsible for a lot of major breakthroughs.

Oftentimes, their devices or technologies are included in household products with hardly anyone knowing about them. Take Immersion (Nasdaq: IMMR), for example. Its vibrating, force-feedback technology (known as "haptics") is included in cellphones and video game systems, making the products more responsive and interactive. It's also a leader in touch-screen technology.

In the investment world, we have a term for companies like this: Small caps.

And you should know that over the long-run, small caps outperform their larger peers...

The Resurgent Power of Small Caps

Over the past year, small caps have outperformed their large cap peers by 9 percentage points.

And the resurgent power of small caps coming out of recessions is legendary. In the 36 months after the end of the past 15 recessions, small caps have beaten large caps by an average of 5.6 percentage points per year.

Now, if you're sitting there, thinking, "Yeah, but small caps are riskier than the big companies," you're right.

Small cap stocks are riskier in that they're often less financially sound. Some don't have much money in the bank. Some have unproven products. And some don't have the experience to bring their products to a mass market... even if they work.

It can be tough sledding, for sure. And it doesn't help when major mainstream outlets like MarketWatch publish negative and misleading anti-small cap articles. Fortunately, my colleague, Louis Basenese, recently stepped up and argued that MarketWatch was wrong about small caps, noting the best ways to invest in the group.

Ultimately, though, if investors are going to assume more risk, the reward needs to be greater. Without that extra incentive, investors would always just play it safe.

And there's the rub: Reward. More specifically, being able to identify the companies that have the greatest risk-reward profile.

Not easy, but potentially lucrative when it happens...

Big News = Bigger Gains For Small Caps

For example, let's say Merck (NYSE: MRK) announces strong data on an important new cancer drug. That's certainly a positive and should cause the stock to rise.

And if a small cap stock like Celldex Therapeutics (Nasdaq: CLDX) announces strong data for its CDX-110 brain cancer drug at the key American Society of Clinical Oncology (ASCO) conference in a few weeks, the stock should also jump a few points.

However, those points would be much more meaningful for a $9 stock than on a $32 stock.

So how can you latch onto potential big winners in the small cap world?

What Aren't the Big Boys Doing? You Need to Know...

One way to do it is by paying attention to what institutions are doing. Or, more specifically, not doing.

You see, many hedge funds and mutual funds don't invest in small caps. Which is why you should.

That's because institutional investing can move small cap stocks. Do your due diligence properly and when the big boys do get involved, their buying power can light a fire under small caps much more than when these firms put their money to work in a larger company.

Think about it. A $10 million investment in a $200 million market cap company is very meaningful. But that same investment in a $20 billion market cap company doesn't have as much impact.

The Small Cap Double

Ask 50 investors what they want most from their stocks and all 50 will likely give you the same answer: Profits.

Well, the small cap world is certainly capable of dishing out big returns.

But the technological advances behind those profits can be just as exciting. I've come across some incredible stories. For example, companies like...

  • Illumina (Nasdaq: ILMN), which maps the human genome process.
  • Energy Recovery Inc. (Nasdaq: ERII), which is in the desalination business - i.e. turning seawater into drinking water.
  • Novatel Wireless (Nasdaq: NVTL), which allows you to pick up the Internet almost anywhere.
  • The afore-mentioned Celldex Therapeutics, busy creating cancer vaccines.

The list goes on. Obviously, not all small cap stocks work out. But there is a lot of profit potential available from these amazing new technologies and products. And the small cap companies that do succeed tend to rise more than other stocks.

There is added risk of course, because not all of the products will work out, but with smart stock-picking, the gains will be well worth the risk.

Hoping your longs go up and your shorts go down.

Marc Lichtenfeld

comments powered by Disqus