Picture this. It’s 3am.
You’re in bed and you should be fast asleep. But you’re staring at the ceiling.
What’s playing on your mind?
Is it the mortgage?
Is it that black spider that crawled behind your dresser?
Or is it stocks in your portfolio that keep you up at night?
If that last part sounds familiar, don’t worry. You’re in good company.
I know I’ve suffered the odd sleepless night thanks to the stock market.
But that might not be such a bad thing.
In fact, it could mean your portfolio is primed for success…
One article caught my eye this week as I scanned through the press.
It was a piece written by American finance pundit Chuck Jaffe. Chuck’s note leads with the headline ‘Always Invest In What Scares You‘.
Smart advice, I thought. But once I read Chuck’s article, I realised that he and I don’t see eye to eye.
You see, although that headline immediately drove me to a certain conclusion, Chuck used it to make a different point.
We can summarise Chuck’s argument with this quote from Dan Dorval of Dorval & Chorne Financial Advisors in Maple Grove, Minnesota:
‘A well-diversified portfolio is almost always going to own something that is currently out of favour.‘
Chuck and Dan point out that it’s important to diversify your investments. They’re saying a long term investor shouldn’t react emotionally to a 5% swing in a market or single stock.
The most recent example of that being January’s emerging market storm in a teacup.
These are both valid points.
But for these guys in the mainstream press, ‘scary’ means ‘any asset that underperformed in the last reporting period’.
I don’t call that scary. I call that boring. What’s more, I call it lazy.
Let me explain…
Most people wait for everything to seem perfect before they buy a stock. They wait until a technology is commercialised, until sales contracts are locked in, or in a broader sense, until the market has risen 10% or 20%.
These people will then sit back and wait for the stock to go up.
That doesn’t work.
For the best rewards, you have to buy into companies that face risks…as long as you can foresee a day when those risks go away.
Take for example Slater & Gordon Ltd [ASX: SGH].
Over the course of 2012, the Australian ‘no-win-no-fee’ litigator’s stock price gained a respectable 23%, plus 3-4% in dividends.
This time last year, Slater’s stock price looked to have hit a ceiling, limited by the risk and uncertainty around the company’s tentative expansion to the United Kingdom.
The UK consumer law market is four to five times larger than that of Australia. It’s ferociously competitive.
But then again, it’s had a few more centuries to develop. And that’s led to a fragmented market.
It’s safe to say entering the UK was a risky strategy for this Aussie law firm.
Well, in 2013, Slater & Gordon went on to outperform every other company in the S&P/ASX 200. Including dividends, the stock returned a massive 118%.
That’s what happens when a firm takes a risk and a daring expansion pays off with greater market share, revenue and profit.
An Investment Rule of Thumb
Sometimes you have to be willing to look stupid in the short term when you own emerging stocks.
But companies and ideas that took over the world usually started out looking stupid.
It just takes patience and time for these stories to move from the fringe of what seems sensible into the mainstream of the investment world.
That’s always an exciting journey. And the best part is that it usually involves a stock price growing in leaps and bounds.
In short, you have to invest in what seems scary today to reap the strongest long term gains.
That’s the message I get from the headline ‘Always Invest In What Scares You‘.
Here’s an investment rule of thumb. Large blue-chip companies lack the gumption that’s needed to pursue truly revolutionary ideas.
These companies can suffer from risk-averse management or even just too many layers of management. They might suffer from a shareholder base that actively dissuades investment in challenging ideas.
Either way, there’s a lack of daring that puts the handbrake on idea generation.
There’s a much smarter way to capture that entrepreneurial spirit and cash in when ideas move from the fringe to the mainstream.
It’s by investing in carefully chosen small-cap companies, like the ones we research and recommend in Australian Small-Cap Investigator.
Look, I won’t pretend that buying stocks at this end of the market is a low-risk strategy.
You should only invest money in speculative stocks that you can afford to lose.
But in the context of an Australian economy that’s ‘just going’, you’ll never bank outsized profits by investing in stories that everyone agrees look soothing and sensible.
You’ve got to leave your comfort zone if you want to fatten up your share portfolio. Don’t bother looking for perfection in your investments.
If you find perfection, you’ll know you’ve already missed the biggest gains.
Instead, look for the risks that a company faces…and try to determine what the company would be worth if those risks went away.
Embrace the risks – yes, some may keep you up at night, but they’re allowing you to get a good price!
There’s every chance you’ll make more money in that mindset than if you shy away from ‘scary’ investments…it could help keep your mind off that black spider that crawled behind your dresser, too.
Cheers,
Tim Dohrmann
Small-Cap Analyst, Australian Small-Cap Investigator
Ed note: By the way, I hope you’ll join me at World War D, our mega event coming up in March. If you don’t know anything about our 2014 show, click here. There are a handful of tickets left.
