We British love a good bargain.

It’s the only rational explanation for why David Dickinson has been allowed to have a regular slot BBC2 for the past eight years.

But our fascination with "real bobby dazzlers" goes beyond the car-boot sale and into the wilds of the stock market. 

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Ask the typical British investor and you’ll uncover a yearning for one or two ‘bargain’ small cap stocks.

The problem is that it could end up being an even more dangerous purchase than that second-hand microwave from the church fair.

Undoubtedly, investing in smaller companies is a potential gold mine. We’ve had some great small cap success stories ourselves, here at Fleet Street Publications.

But let’s put that concept, the ‘bargain,’ under the microscope.

Bargain hunters beware!

When you hear bargain, you’re thinking value. And value is the Mecca (the promise land, not the bingo hall) of private investing.

In investment terms, a ‘value opportunity’ is a stock that trades at a price that is justifiable by the amount of money it makes.

When a firm’s stock trades at a price that cannot be justified by its margins, it is said to be overvalued.

Though I’d like to challenge the conventional view of value...

The P/E, or Price-to-Earnings ratio, is popularly regarded as the kingmaker in valuation judgements.

If a firm has a low P/E — i.e. a low stock price in relation to the firm’s earnings — it is said to represent good value.

Conversely, a firm with a high P/E represents poor value.

The rationale for this is simple:

A high priced stock could be down to investors ‘bidding up’ or driving the price up by buying lots of stock in order to capitalise on the firm’s good fortunes.

A stock that has already been heavily ‘bid up’ represents little opportunity for further gains... at least in the short term.

A low priced stock is potentially that opportunity for gains. A firm that is relatively undervalued. Stocks in this condition can yield big gains if an eruption of ‘bidding up’ reaches the firm.

In short... buy low and sell high.

But, I’d like to introduce a caveat to the value philosophy to protect against overloading your portfolio with small caps... market capitalisation.

Big is beautiful for private investors

I’m not anti-small caps, but I do think they should come with a wealth warning:

CAUTION — These stocks should only be handled with the assistance of trained professionals. Seek approval from your financial advisor before investing.

Why the caution?

Because small caps are predisposed to being more volatile.

Their greatest strength is often their biggest weakness... specificity.

Small caps tend to offer a very explicit opportunity.

These firms are specialists operating within the scope of one single economic micro trend.

A debt solution provider in Scotland or a solar panel developer in Malta or a... you get the idea.

A small cap stock’s focus on a specific thing means that when that thing takes off, the stock price will accelerate wholeheartedly.

Unfortunately, the same is true on the downside.

A firm is celebrated for its focus on the way up. But it is scorned for its lack of diversification on the way down.

And when this happens, when the demand for the products these companies supply dries up, they don’t look like such great bargains.

Larger companies rarely have this problem, particularly at the really big end of the market.

There are more than 20 firms valued over £25bn in the index... a special group known as the mega caps. 

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Mega caps tend to have so many business lines and operate in so many regions that they are perpetually hedging their bets.

If one operation goes bust, no problem. There are many other profit streams to take its place.

It’s not daring but it is this kind of safe playing that could make (and more importantly save) you money in such an uneasy market place.

But surely, if you bought enough small caps some of them are bound to take off? Wouldn’t it be more lucrative to buy a few speculative investments and hope for the best?

We say no, and the evidence agrees.

Tale of the tape During the 2003 - 2007 bull-run here in the UK, small caps were in vogue.

They outperformed their larger peers by some way.

However, the tide has now turned. Over the past 12 months, Small cap indices have underperformed the FTSE 350. Interesting to add, mid-caps have also been losing out to the big boys.

The FTSE 250, the mid cap index, underperformed the FTSE 100, the large cap index, over one, three and twelve months.

This is a new phenomenon. Small caps and mid caps are used to being ahead of the FTSE 100.

What has sparked the shift?

Pessimistically, I think it is a case of being the least worst option. Over the past twelve months, most stocks have been hit hard.

The credit crunch was not prejudiced in knocking all markets off of their highs. However, the large caps were the most resilient to the storm.

Looking at the drivers of growth during the bull-run, we can see why.

Takeover talk — The acquisition boom, made possible by the prevalence of cheap debt, was a big help to small caps. Conversely, many FTSE 100 firms were too large for the market to seriously entertain a buyout bid.

As a result, there wasn’t much froth in mega cap stock prices, hence less far for them to fall.

Sentiment — Investor opinions got negative. And this reduced investors’ risk tolerance, sparking what is known as a mass sell-off, or ‘flight to safety’ in broker-speak.

When the appetite for risk dies down, it is small caps that feel the pain worst. This ‘flight to safety’ manifested itself as going for big stocks with defensive credentials. This is something the FTSE 100 has in droves.

You get the idea... large caps are a safer play for a rainy day.

And it’s pouring.

This is why I’m not recommending you go and buy an index tracker.

A stock pickers’ market

Having settled on large caps as the least worst option in the market, blue chips are the current champions of comparative advantage.

But buying into the whole FTSE 100 index would expose you to some potentially dangerous positions.

The reason for this is that nearly 11% of the index is made up of the number one culprit in this whole sell-off... the banks.

Barclays, RBS, HBOS, Bradford & Bingley and Alliance & Leicester... all down over 40% or more since the beginning of the year. I won’t even quote Northern Rock!

Why anyone other than the most hardened of contrarians would want to expose themselves to bank stocks is beyond me.

Every opportunistic commentator to call a bottom on this poisoned sector has been proven wrong so far.

If we’re honest... no one really knows when the credit crunch will be over.

The bank problem means it is smarter to pick stocks than to take on these inevitable laggards in a large cap index fund.

So when picking, keep your wits about you and remember why you are buying large caps in the first place.

This category of stocks allows you to sidestep the troubled UK economy and take advantage of growing worldwide trends... play the large cap market for what it is.

The FTSE 100 is a window on the world, a truly international index that gives investors a local piece of a global pie.

It is stacked with many of the world’s best firms, some of which that do none of their business in the UK.

This is the real bargain. The kind of bargain that the Fleet Street Letter, Profit Hunter and Smart Commodities is here to identify.

With the industrial growth in emerging markets and the rising price of commodities, we maintain that it is the type of investment you should be looking to add to your portfolio too.

Theo Casey

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