I sold my stocks in advance of earnings season, because my wife and I recently put a contract on a house. It was bittersweet; I was excited to be a homeowner but sad to see my holdings go. Then I watched in even greater dismay as Dawson Geophysical (NASDAQ:DWSN) shot up more than 14% on earnings.
Yet the market quickly reminded me why I was smart to sell:
- Natus Medical (NASDAQ:BABY), down 18%.
- American Financial Realty (NYSE:AFR), down 10%.
But before I could feel satisfied with myself:
- Blackboard (NASDAQ:BBBB), up 17%.
Volatility, thy name is small caps.
The crazy market
I sold in advance of earnings because -- even though I was confident in my long-term holdings -- I had no idea what to expect over the next month. The market is a fickle place, and even the Warren Buffett-smart have said that they have no idea what will happen tomorrow.
This is a market that won't hesitate to add or shave millions of dollars off a retail company's market cap based on monthly sales. Sports apparel company Zumiez (NASDAQ:ZUMZ), for example, moved up more than 7% when its April same-store sales increased 19.3%. While that's an impressive number, is it rational for a company to be worth $60 million more -- in a matter of hours -- based on one month's data?
Even $6 billion Abercrombie & Fitch (NYSE:ANF) moved up 5% when its same-store sales increased 17% for April.
Conversely, Aeropostale (NYSE:ARO) dropped 11%, even though same-store sales rose 8.4%, because the company said it would hit the lower end of its quarterly guidance. The market valued Aeropostale nearly $200 million less than before based on three months of activity.
That's crazy!
The easy way
But hey, it's an accepted fact that the market is crazy in the short term, and that the market is particularly crazy when it comes to small caps. That's because small companies don't trade as many shares and don't receive as much coverage as the big guys.
That said, there two things we do know about small caps:
- They offer the best returns; and
- While earning those returns, small stocks will drop precipitously along the way.
So what's the easy way to earn better returns? First, buy small companies with superior management and wide market opportunities at good prices. Next, hold those small companies for the next 10, 20, or even 30 years.
More free advice
I know that two-step plan sounds too good to be true, but it is a recipe for market-beating returns. There will, however, be hiccups along the way. That's why we also advise members of our Hidden Gems small-cap investment service to follow these five maxims as well:
- Broadly diversify in small caps.
- Invest new money on a regular basis.
- Eliminate emotion from decision-making.
- Expect mistakes.
- Scale back any individual position, or your exposure to stocks, if you're fretting over its volatility.
The Foolish bottom line
If you decide to heed these lessons (or join Hidden Gems), you're on your way to better returns. Remember, however, that they only work over long timelines. So don't go investing in small caps if you need money next month to, say, buy a house.
Fool co-founder Tom Gardner and analyst Bill Mann are beating the S&P 500 by more than 25 percentage points since 2003 with their stock picks in Motley Fool Hidden Gems. Click here to join the service free for 30 days.
Tim Hanson continues to own small positions in Hidden Gems picks Blackboard and Dawson Geophysical. American Financial Realty is an Income Investor recommendation. No Fool is too cool for disclosure ... and Tim's pretty darn cool.
