Investor behavior has always been very interesting to me. Why do so many investors feel more comfortable buying near all-time highs as opposed to buying during or after a market sell-off? There are countless studies in the field of behavioral finance that demonstrate that short-term price movements in stocks and the overall market have little to do with fundamentals or economic trends. Rather, broad market moves are heavily, if not solely influenced by investors' emotional reactions to news events, ergo the "herd" mentality.
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As the chart below indicates, investors' emotions seem to fluctuate and dictate behavior that contradicts the well-known "buy low, sell high" idiom. For instance, in 2010, the S&P 500 (^INX) fell by as much as 16% from its yearly high before rebounding – clearly a good entry point that few took advantage of as investors feared that the bull run had come to an end.
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Now that the S&P is trading at all-time highs again, many investors are joining the crowd and are buying large-cap stocks -- not because they believe they are undervalued or because they feel the economic outlook is particularly strong, but because stocks are up. To that end, I've also identified a sub-trend in 2013: investors' bias toward large company stocks; that is, a bias toward household names that investors are comfortable with.
Coca-Cola (KO) is one of the best-known brands in the world, as is Microsoft (MSFT). Ask yourself this: If your broker or adviser called you and said he or she wanted to buy Coke and Microsoft, would you argue? Now think about how you would behave if he or she asked you to invest in Muller Industries (MLI) and Wolverine World Wide (WWW). You might question him or her a bit more, no? These two small-caps are part of my firm's low-volatility small-cap portfolio – the Small Cap Buster Program. MLI manufactures copper, brass, plastic, and aluminum products used in plumbing and refrigeration equipment. The company has operations across the globe. WWW manufactures, markets, and distributes footwear and apparel, including the Harley-Davidson line of clothing, Hush Puppies shoes, Patagonia footwear, and more.
I believe small-cap value stocks could become (actually, I should say could remain) market leaders. Although small-cap stocks have outperformed their large-cap brethren, small-cap fundamentals and valuations remain more attractive. While S&P earnings have only grown by roughly 5% over the past 12 months, small-cap earnings have increased by over 9%. Moreover, revenue growth and future growth expectations for small-cap stocks are much stronger than they are for large-cap stocks. Many of the lower-volatility small-cap stocks also have better profit margins than their large-cap counterparts. While many large companies have improved margins and profits through aggressive cost cuts, small-cap stocks have done so through product innovation, international expansion, and growing their businesses overall.
Keeping your emotions in check and avoiding a bias towards the comfortable is paramount to a successful investment strategy. The best traders and investors, from hedge fund managers to Warren Buffett, are all able to avoid these psychological temptations. Hopefully, now that you are more aware of them, so will you.