On Wednesday, I said that the FTSE 100 isn’t bad value – at least not compared to houses! Trading at 12 times earnings, the FTSE 100 is actually lower than its historic average. And I wasn’t surprised to see the index blast through 6,200.
I mean, there’s a lot of new money appearing on the scene. Many investors have grown tired of sitting on the sidelines. And they probably like the look of the relatively decent 3.5% return they are getting in income from the FTSE big boys.
But it’s true that many of the large cap stocks look a bit long in the tooth. The nimbler FTSE 250, which includes many smaller companies, has actually performed much better than the elders. But if you want a slice of that action, it’s gonna cost you. 19 times earnings is what you’ll pay. The yield on the faster moving 250 falls to 2.7%.
Still, that hasn't stopped investors from pilling into these small stocks. And as I'll explain today, that is becoming a very dangerous game indeed...
This is dangerous ground
The FTSE Small Cap index is the next rung down the ladder from the FTSE 250. It’s the next 250 stocks. We’ve already seen that as you head down the league table, you pay more for your stocks. But I think this might shock you: they’re trading on an average 45 times earnings! To put that in context, it means that on today’s figures, you’ll have to wait 45 years for your investment to earn back the money you put in!
And if you travel as low as the FTSE AIM market, you’ll find that, taken as a whole, there are no earnings at all! The guys that organise the index therefore can’t even give us a price/earnings (p/e) ratio.
I accept that there’s a whole gamut of stocks floating around in the small-cap universe – some undoubtedly with great merit. But there’s a hell of a lot of trash. Without earnings, much of them are more like gambles than investments. And they are expensive gambles at that.
If you invest here, I think you stand a very good chance of losing money. In my experience, the small-cap market is a dangerous hunting ground.
That doesn’t stop private investors from taking a big interest in these stocks however. Yesterday I was on the train and stuck for a few minutes. I found myself clicking on the link for the most accessed threads on a popular investor’s bulletin board.
It turns out that of the nine most popular stock threads, eight were small-cap resource stocks (miners and oil explorers) – the only biggie was Vodafone. I was quite shocked by that.
The point is that these little stocks generate a fantastic amount of noise. They take up a lot of investors' time, and moreover, they lose investors a lot of money.
Just look at the charts of today’s three most hotly debated stocks and I think you’ll agree. These are not the sorts of things you want to fill your portfolio with....
An exclusive report from The Right Side
Hot stock 1: Gold Oil
Hot stock 2: Gulf Keystone
Hot stock 3: Xcite Energy
Given that many private investors probably get suckered in on the wild up moves, it’s clear that there have been great losses on the majority of these stocks.
To be honest, I think many of these stocks will probably end up in the knacker’s yard. Maybe I’m just being cynical. But the way I see it, a lot of this stuff has been floated to an unsuspecting public in a bid to make the backers rich.
I’m talking about the accountants, lawyers, banks and so-called 'entrepreneurs' that help bring these stocks to market. And getting this stuff to market requires a fantastic story – and quite literally, much of the small-cap resources sector is fantasy – much of it written by a clever City PR firm.
So, while it might be fun – I’m certainly not above a punt or two – I worry about the amount of attention these stocks get among private investors. Especially now…
Out of the frying pan and into the fire
2013 saw the dawn of a new era for the finance industry. The Retail Distribution Review (RDR) sees commission on financial advice kicked into touch. Fantastic! You can read all about what it means for you here.
But there is a sting in the tail...
I suspect that many private investors will be loathe to pay advisers for counsel on how to invest their hard-earned cash. Many will plough their own furrow. And in many cases, it’ll cost them dearly. I know – I’ve been doing this stuff since I was a teenager. And believe me, I’ve made all the mistakes you can make!
I can see many small investors wasting fruitless hours chasing the ‘fascinating’ stories of small-cap resource stocks. And this is not good enough!
I am proud to say that MoneyWeek campaigned incessantly for fair treatment on investment commissions. And now that it looks like we’ve got it, I think it’s time to move the battle lines forward.
We need to look at the mess that constitutes the dark side of the stock market. That is, the small caps and AIM markets. AIM in particular needs to take a good, hard look at itself. Companies floated purely to make money for the industry and somehow provide investor entertainment is clearly wrong.
While we stoke up the debate on that, may I offer some advice...
Beware the fantastic stories that do the rounds on investor forums. Bulletin boards can be a great place to find out information on stocks. But the best way to look at them is usually as a contrarian indicator. The greater the story, the greater the noise and razzamatazz... the greater the fall.
So if you are tempted by this side of the market – then for heaven’s sake, buy the stock when it’s trading near its lows. These sort of stocks can offer marvellous potential. But only if you get your timing right!
So do your own homework and do it diligently. Only invest in companies that have decent cash backing, as a company coming back to the market for more money will trounce your investment.
• This article is taken from the free investment email The Right side. Sign up to The Right Side here.
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