Do you want to earn big? You have got to think small...

Why is small better?

Small stocks are being viewed as an attractive investment. An article in the Wall Street Journal discussing this trend starts in the following way: "International investors are starting to think smaller. They should have started earlier" (From: http://online.wsj.com/article/SB117486630727948482-search.html?KEYWORDS=karmin&COLLECTION=wsjie/6month).

However there are some major concerns present in the common perception of small stocks. Small capitalization securities tend to be more volatile and hence more risky. Less data is provided for such companies, due both to the fact that smaller companies cannot produce a given level of financial data, as well as, because they seem to be out the focus of most analysts. Do the given above reasons determine that small stocks are not as valuable as an investment option? Not necessarily...

TINSTAAFL... or is there?

The acronym above means, "There is no such thing as a free lunch", and is widely used in economics and finance literature. In finance, this statement applies to the fact that an investor has to bear additional risk in order to achieve a higher return rate.

Surprisingly, small stocks seem to defy this rule and provide "a free lunch" on a regular basis. Historically, small stocks have brought higher returns than big stocks. The Wall Street Journal states: "Small and midsize stocks in Europe, Japan and other corners of the developed world have offered some of the best earnings growth anywhere in recent years. These stocks returned 25% a year, on average, for the five years through December, according to Morgan Stanley Capital International. Like U.S. small-capitalization stocks, small-cap foreign stocks outperformed large-cap foreign stocks for each of the past six years. Up 7% year-to-date, foreign small stocks are ahead again this year." (From: http://online.wsj.com/article/SB117486630727948482-search.html?KEYWORDS=karmin&COLLECTION=wsjie/6month). Analyzing any kind of historical market data should lead to the same conclusion.

This characteristic might be explained by a greater risk present while investing in small caps. However, financial research and empirical evidence seems to prove that, as Robert Strong, CFA puts it, small stocks provide a higher risk adjusted rate of return. Additionally, this outcome seems to be persistent. (See: Strong, R., Portfolio Construction, Management & Protection, 4 edition, Thompson Southwestern, 2006, p.249.). This is commonly known as: "small firm effect - The tendency for firms with low levels of capitalization to perform better than finance theory suggests they should". (From: http://websites.swlearning.com/cgi-wadsworth/course_products_wp.pl?fid=M20b&product_isbn_issn=0324232586&discipline_number=414 ). Known financial researchers, Prof. Eugene Fama and Prof. Kenneth French have researched the topic in detail, one should turn to their work for further information about it.

International diversification allows achieving a level of risk, which is approximately the half of the risk borne in a well-diversified domestic stock portfolio. Well established capital markets in Europe and Japan exhibit a similar form of market efficiency as the US markets, furthermore they do know carry excess volatility of emerging markets. Investing in small caps in developed international markets seems to be a very attractive option, carrying moderate risk and a premium risk adjusted rate of return on average, when compared with the large caps. That just brings an annoying thought that the US investors should have thought about foreign small caps earlier...

Digi-sue-them

The age that we are living in does not cease to amaze me. It is not about the gadgets and useful electronic devices we own. The completely new information and entertainment channels are the major achievement. Bloggers culture springs, giving a voice to virtually anyone and sites like YouTube, AOL videos, as well as similar ones supply the internet users with millions of funny, scary or just interesting clips, both long and short.

Google Inc. recognized the potential of YouTube and decides to make a move before any of the competitors did, acquiring the site for a whooping 1.7 billion $ last year. The popularity of YouTube was and still is its greatest asset, the downside of the page was that everybody could have uploaded anything desired. This means - copyrighted material was available on YouTube and intellectual property rights were violated.

The question that has risen is - how are issues like that going to be handled in the digital internet hooked society of today and tomorrow? Viacom is the owner of some of the copyrighted material viewable on YouTube. This entity's answer was a 1 billion $ lawsuit against Google Inc. Viacom's press release read, among other: "YouTube is a significant, for-profit organization that has built a lucrative business out of exploiting the devotion of fans to others' creative works in order to enrich itself and its corporate parent Google. Their business model, which is based on building traffic and selling advertising off of unlicensed content, is clearly illegal and is in obvious conflict with copyright laws", as well as: "There is no question that YouTube and Google are continuing to take the fruit of our efforts without permission and destroying enormous value in the process. This is value that rightfully belongs to the writers, directors and talent who create it and companies like Viacom that have invested to make possible this innovation and creativity" (For the whole statement see: http://online.wsj.com/article/SB117379240271535457.html?mod=home_whats_news_us ).

In my opinion, this case bears a lot of similarity to the Napster issue. The fundamental question is: can a for-profit organization earn money advertising while offering free entertainment to internet users? There is only one catch here: the content is copyrighted, so an organization earns money using someone else’s work! On the other hand: "Google supporters say YouTube's actions simply reflect the evolution of what an Internet company does and that protections intended for Web hosts in general should apply." (From: http://online.wsj.com/article/SB117379140954435400.html?mod=home_whats_news_us ).

The fundamental difference between Napster and YouTube is the scale of the problem - there are far more YouTube users, than there were Napster users.

The lawsuit was filed after failed licensing negotiations between Google Inc. and Viacom. Viacom asked Google to remove the copyrighted content, which was apparently not done. Viacom vs. YouTube is the biggest problem, but it is not the only problem concerning copyrights of digital entertainment content. TimeWarner has similar worries about its content on YouTube, but it is willing reach a compromise with Google. Universal Music Group vs. MySpace is yet another pending big case worth mentioning (For more on all those cases, see: http://online.wsj.com/article/SB117379140954435400.html?mod=home_whats_news_us ).

The outcome of this case holds great significance. It is possible, that the way this case is resolved might set the benchmark for future issues of similar nature.

Bleak seasons coming, or just a passing shower?

This week we have once again witnessed that the world is one global market place, and stock markets cannot be viewed in isolation. Tuesday's 9% plunge of the Chinese Shanghai index sent stocks in the US and Europe falling. Dow Jones reacted with a 400 points drop, erasing last week's record high, S&P 500 and NASDAQ also noted substantial losses. (More on that: http://online.wsj.com/article/SB117260706682921020.html and: http://blogs.wsj.com/marketbeat/2007/02/27/china-no-its-not-just-china/ ). The situation is even more serious due to the fact that Far Eastern markets, Chinese in particular have been an attractive place for US and European based capital lately. However, many have probably forgotten that this market carries high volatility along with the attractive returns.

Alan Greenspan also contributed to investors insecurity as the word recession was among the ones he used while speaking to investors in Hong Kong (More on the possible effects of this speech: http://www.ft.com/cms/s/2ad62eba-c6d1-11db-8f4f-000b5df10621.html ). Mr. Greenspan's words were interpreted as a prediction of a recession in this year. The former FED's boss's expert status added weight to the claim and certainly did not help the stock markets, which reacted severely to mixed economic data (See: http://online.wsj.com/article/SB117249340786119234.html ).

Another possible reason contributing to the drop is a apparent change in investors attitudes, which seem to change towards putting capital into less risky investments than before. (The Wall Street Journal reports on that: http://online.wsj.com/article/SB117271330926722830.html?mod=home_whats_news_us ).

Just a Shower, or the eye of the Storm?

All in all, the question rises: was this just a single event, or are encountering a bearish period? US Federal Reserve Chairman Mr. Ben Bernake came to the rescue first on Wednesday, when he confirmed his previous US economy outlook for "moderate growth" and referred to the financial markets as being "closely monitored" and "working well" (See: http://online.wsj.com/article/SB117267441551822115.html ). After that, Mr. Greenspan has down-played the tone of his previous utterance (More on that: http://online.wsj.com/article/SB117272314862823068.html ).

The US market reacted well to those news and even though they did not rise, they stopped the rapid losses, as of now all the major US indices have only very marginal losses (See: http://online.wsj.com/article/SB117275252509823347.html?mod=home_whats_news_us ). The fall in the Treasury bills price may indicate that the investors a willing to bear some risk again.

The long term question remains - are the stock market players going to be more risk averse after this weeks events? Regardless of that - if the moderate growth economic outlook holds for now, investors should be able to record gains on their securities in an intermediate time span.