Asymmetric Risk and Small Cap Investing
“In investing, what is comfortable is rarely profitable.”
– Robert Arnott
What is Asymmetric Risk?
Asymmetric risk is an investment scenario where the potential for profit or loss is imbalanced: the risk is not equal to the potential reward. As an example, if you were to risk $5 playing slots at the casino, but the potential return is $30, this would be considered an asymmetric risk.
Conversely, symmetric risk is where risk and reward potential is balanced—profit potential is the same as profit loss.
In a symmetric risk scenario, the casino slots would have a $5 risk for playing and $5 reward for winning.
Positive Versus Negative Risk-Reward
Diving a little deeper, asymmetric risk can be positive or negative.
In a positive risk-reward scenario, you can only lose an amount that is smaller than the potential gain or reward.
Risking $5 on slots to win a potential $30 is a positive risk-reward scenario.
With a negative risk-reward scenario, you can lose more than what the potential positive reward is.
If you find a slot machine that costs $5 to play, but it offers a maximum reward of $1 if you win, your risk-reward is negative.
The Asymmetric Opportunity Hidden in Small-Caps
An asymmetric investing strategy leverages positive risk-reward opportunities for maximum returns.
Investors will look to identify situations when the upside investing potential is much greater than the potential downside, or the downside is limited but the upside is unlimited.
As a retail investor, the most profitable risk-reward opportunities can be found in small-caps.
It’s a bit of a conundrum.
Despite being earlier stage companies and more vulnerable to failure and short-term volatility, small-caps offer unlimited upside potential, relative to limited downside potential.
The math that supports this strategy is simple: stocks can only go down 100%, but their potential upside is infinite. Because you can buy shares in small-caps at a lower price compared to large caps, and earlier stage small-cap companies have unlimited potential for future growth, small-cap stocks present a positive risk-reward scenario in which the downside is considered limited, while the potential upside offers an asymmetric profit opportunity.
As already-matured companies, large-cap stocks are less likely to double or triple their market cap than small-cap stocks. Investors who put their money into large-cap stocks might feel safer because these companies are more stable, but the likely outcome is these risk-averse investors will only see modest gains over the long-term.
Small Bets Can Reap Huge Rewards
Let’s say you have $1,000 to invest.
You could put that money into a large-cap Amazon stock, and buy a fraction of one share.
While Amazon was once a small-cap stock with plenty of room for growth – and unlimited upside potential, the company has most of its formative growth behind it. It’s going to be very difficult at this stage for Amazon, to double its share price with a market cap of US $1.6 Trillion.
And even if it can double its share price, your $1,000 will only become $2,000 (assuming there are no changes to capital structure).
Your profit – if you sold it all – would only be $1,000: the same amount that you risked in the first place.
Now, let’s say you have another $1,000 to invest.
You select a small-cap stock with solid fundamentals that you believe is currently being undervalued, and is trading at US $1.38 per share. This price would allow you to buy 724.6 shares of stock.
Over the next two years, the company makes several smart moves reducing its overheads and introducing new product lines to increase sales and net profit. The institutional investors start buying and the stock price begins to climb, eventually reaching $29.
Your initial $1,000 would now be worth more than $21,000 – that’s a $20,000 profit in just two years.
The above scenario may seem too good to be true, but it’s a real example of a Canadian company called Xpel Technologies (NASDAQ: XPEL).
XPEL was trading at just US $1.38 in February 2018, after hovering between $0.80 and $2.00 per share for several years beforehand.
Today it is trading at around $25, after having reached a high of $29 in August 2020.
While this kind of opportunity is not necessarily easy to find, there are many more examples of small-cap success stories just like it.
Zynex Inc (NASDAQ: ZYXI) was trading at $0.22 in 2015 and is now trading at around $16 (as of Sept 17, 2020).
Xebec Absorption (TSX-V: XBC) was trading at $0.07 back in August 2015 and is now trading at $4.40 (Sept 2020).
These potential multibagger opportunities do exist in the market. As the retail investor, you can make huge gains if you discover them early.
Developing Your Own Asymmetric Investing Thesis
Adopting an asymmetric investing strategy is essential for any retail investor aiming to beat the standard market return.
In order to do so, look for positive risk-reward scenarios that offer an unlimited potential upside and a limited downside.
The best place to find these opportunities is in undiscovered, undervalued small-cap stocks.
It is true that part of a successful investing strategy should focus on mitigating risk. Small-cap stocks are certainly not without risk – but you can lower the chances of losing money as an investor by developing your skillset, and finding your edge.
As a retail investor, you have the ability to research small-cap public companies from all over the world in order to discover high quality, undervalued opportunities that could deliver asymmetric profits.
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