It seems that more and more mutual funds and exchange-traded funds (ETFs) are resorting to gimmicks to lure investor dollars. Case in point: TheNew York Times recently profiled the StockCar Stocks Index fund (SCARX), which invests in all things NASCAR -- race track operators, TV partners, and corporate sponsors such as Caterpillar (NYSE:CAT).
Then there's the First Trust IPOX 100 Index (FPX). With holdings such as Seagate Technology (NYSE:STX) and Chicago Mercantile Exchange (NYSE:CME), this ETF attempts to match the IPOX 100 index, which begins tracking initial public offerings on the seventh trading day after a stock enters the public markets and automatically drops it after 1,000 trading days.
That's not really what we mean by "barely legal," though
Though some of these young stocks can lead to market-beating returns, we propose a better definition for barely legal stocks: small- or micro-cap stocks that have little to no analyst coverage.
That's because these barely legals can be dangerous. Since there aren't any analysts on the scent, revenue and earnings estimates are rare. Worse, they can be hyped by unscrupulous opportunists. And the volatility can be gut-wrenching -- it isn't uncommon for these stocks to move up or down 10% or more on any given day with no news.
Guys, you're stretching it .
Maybe so, but stay with us. Another new ETF coming to market -- one we're more excited about -- will invest entirely in these barely legal stocks. The logic being that unfollowed equities are more likely mispriced or misunderstood or -- better yet -- mispriced and misunderstood.
And, as we've found, woefully mispriced (on the downside, of course) and misunderstood small companies are precisely the stocks that offer the best returns on the market.
So what's the skinny on the ETF?
Claymore Advisors is the shop planning to launch the "Stealth Portfolio ETF."
And while there are a lot of numbers available that show the rewards of small-cap value, barely legal stocks can also be some of the worst stocks you can buy, so we recommend treading carefully. Indeed, as Claymore notes in its SEC prospectus, "Micro-cap stocks involve substantially greater risks of loss and price fluctuations because their earnings and revenues tend to be less predictable. . In addition, there may be less public information available about these companies."
May be less public information? That's an understatement. BTU International (NASDAQ:BTUI) and TGC Industries (AMEX:TGE) are two micro caps we've been looking at recently. But it's difficult to quickly get up to date on these operations. A check of our Thomson data service shows that just one analyst follows each of these companies.
The financial stories of Oracle (NASDAQ:ORCL) and Texas Instruments (NYSE:TXN) are much more specific, where 25 and 35 analysts check in, respectively.
When smaller is bigger
Combine unpredictability with a dearth of information, and you can see why there's risk in these stocks. Remember, though, where there's risk, there's reward, and rewards are why we invest in the first place.
Assuming its expenses are low, the Stealth ETF might be a sensible way to get in the small- and micro-cap game. It will hold approximately 250 of these barely legal stocks with diversification broad enough to temper some of the volatility.
The ETF, however, is strictly quantitative. And while there is something to be said for quantitative investing strategies, we believe at our Motley Fool Hidden Gems small-cap investing service that qualitative factors such as quality of management can have a profound effect on the futures of small companies. That's why in our small-cap research we look closely at the insider ownership, CEO tenure, and corporate culture of prospective recommendations.
The Foolish bottom line
Almost all investors should allocate at least a part of their portfolio to small or micro caps -- the potential gains are great. An ETF like Claymore's is one way to do that. But if you'd like to learn more about picking the best small companies for yourself, consider joining us at Hidden Gems, where we blend the qualitative and the quantitative in search of the market's best small- and micro-cap companies. Our picks are beating the large-cap-laden S&P 500 by 14 percentage points on average. Read through more than 40 active recommendations and entire list of micro-cap Tiny Gems -- with no obligation to subscribe -- by clicking here.
Tim Hanson and Brian Richards read The Economist for the articles. Really. Seriously. Neither owns shares of any company mentioned in this article. The Fool's disclosure policy is rockin' steady.
