“An asymmetrical bet is a coin flip where tails I win, heads I don’t lose much.” – Mohnish Pabrai, famed value investor.
Most charts highlighting risk-to-reward ratios move in a straight, upwards line. The more risk, the more reward, and vice versa. However, as small cap investors, we think following these charts is the easiest path to mediocre returns.
What if you could engage in a controlled bet in which the upside massively outweighs the downside? A situation that only calls you to risk $1 to make $10 (or much, much more)?
You may recall a few scenarios from our Options Trading For Dummies series in which your upside and downside is fairly controlled. But asymmetrical bets actually exist in all kinds of financial instruments, within all sectors of the market.
Let’s dive into the world of these highly sought-after investments.
Small Cap Public Companies
Ah, our favorite type of company.
Early stage, innovative, and ideally – disruptive.
Small cap stocks typically bear a higher risk, higher reward ratio due to the companies’ smaller valuation (therefore giving potential for more room to grow). It is common for small cap companies to increase by 50%, 100%, 200%, or even more within a single year. This magnified growth surpasses most indices and large cap stock returns by a long shot.
The drawbacks to a higher return potential are typically lack of share price stability, volatile movements, and, of course, the return to earth after a large run. As quick as a small cap’s price can rise, it can drop. We also want to specifically note that just because a company is small doesn’t mean they’re going to be a big winner. So, how do we assess a small cap stock to determine it’s an asymmetrical bet?
There are a few factors that can point create a favorable risk-reward profile for a small cap stock.
1. Timing – For this strategy, you’ll want to take a bet on a small cap company that has a lower valuation due to it still being early on the scene. The lower the company is valued, the more room there is to grow; however, be sure to evaluate the business’ cap table to make sure that its small size isn’t backed by an… overly generous structure for a select few.. This ties in directly to seeking a conservative share structure, as you may have read in our Private Placements 101 article.
2. Moat – How easy is the barrier to entry? An asymmetrical bet of a small cap company should have a business model and mandate that is not easily replicable. The greater the barrier to entry, the lower the likelihood of a competitor coming in, taking their idea, and executing better.
3. Simultaneous relevance & uniqueness – A small cap company poised to prove itself as an asymmetrical bet should reside within a sector that carries a high level of interest and attention from retail and institutional investors alike. Within hot sectors (such as psychedelics, plant-based food, and battery metals), there is often a lot of saturation. Many different companies seeing similar possibilities and trying to achieve the same goal. An asymmetrical bet in the world of small caps should bear a unique mandate and/or business model, within a relevant, popular sector.
Small Cap Public Companies
Ah, our favorite type of company.
Early stage, innovative, and ideally – disruptive.
Small cap stocks typically bear a higher risk, higher reward ratio due to the companies’ smaller valuation (therefore giving potential for more room to grow). It is common for small cap companies to increase by 50%, 100%, 200%, or even more within a single year. This magnified growth surpasses most indices and large cap stock returns by a long shot.
The drawbacks to a higher return potential are typically lack of share price stability, volatile movements, and, of course, the return to earth after a large run. As quick as a small cap’s price can rise, it can drop.
We also want to specifically note that just because a company is small doesn’t mean they’re going to be a big winner.
So, how do we assess a small cap stock to determine it’s an asymmetrical bet?
There are a few factors that can point create a favorable risk-reward profile for a small cap stock.
- Timing – For this strategy, you’ll want to take a bet on a small cap company that has a lower valuation due to it still being early on the scene. The lower the company is valued, the more room there is to grow; however, be sure to evaluate the business’ cap table to make sure that its small size isn’t backed by an… overly generous structure for a select few.. This ties in directly to seeking a conservative share structure, as you may have read in our Private Placements 101 article.
- Moat – How easy is the barrier to entry? An asymmetrical bet of a small cap company should have a business model and mandate that is not easily replicable. The greater the barrier to entry, the lower the likelihood of a competitor coming in, taking their idea, and executing better.
- Simultaneous relevance & uniqueness – A small cap company poised to prove itself as an asymmetrical bet should reside within a sector that carries a high level of interest and attention from retail and institutional investors alike. Within hot sectors (such as psychedelics, plant-based food, and battery metals), there is often a lot of saturation. Many different companies seeing similar possibilities and trying to achieve the same goal. An asymmetrical bet in the world of small caps should bear a unique mandate and/or business model, within a relevant, popular sector.
Risk-Mitigated Trades
There are several ways to manufacture an asymmetrical bet simply by using basic trading tools. The risk-mitigation trades outlined here are intended for shorter term swing trades, whereas asymmetrical bets on small cap companies can often last years, or even decades.
Did you know? A “swing trade” is a strategy involving catching a significant movement in a stock price. A trader anticipates a “swing” in a stock’s price resulting from a variety of reasons, including but not limited to technical stock movements and/or event-driven fundamental business changes.
Before we get into that, lets briefly outline some basic trading terms.
- Market order – a buy or sell that simply executes based on the best price available.
- Limit order – a buy or sell that only executes when a certain price is hit. If this price is not hit, the order will not be executed.
- Stop loss – a term used to refer to limit sell orders placed strategically below the market price of a stock. This limits the amount of loss that can be incurred through a position.
- Exit order – a term used to refer to a limit sell order that is strategically placed higher than the market price, in order to capture a portion or all of a capital gain without having to be present and watching the market.
When taking a trade and morphing it into an asymmetrical bet, the beauty is that you can decide your desired risk-to-reward ratio based on where you place your stop loss and your exit price.
If you wanted to “risk a dime for a quarter,” you might place a stop loss at a price 10% below market price, with an exit order that is 25% higher than the market price. This ensures you can only incur a 10% maximum loss or receive a 25% maximum gain.
This strategy casts a net of certainty, knowing that one of the two outcomes will likely happen.
It is important to note that placing your “exit order” is generally only necessary if you are not able to (or don’t want to) monitor the market. However, unless you are abundant with knowledge on either technical chart analysis or are confident on a solid, educated thesis based on news or events, having an exit order tailored to your preferred risk-to-reward ratio is useful for combatting the emotions of a trade.
Another method of disconnecting emotions when monitoring your trades is by implementing partial sell orders on the way to your exit price. While this inherently shaves off some reward as your position decreases, it adds peace of mind by proportionately reducing the risk.
The first worst-case scenario within a risk-mitigated trade using these methods would be the stock price reversing just short of your exit price, before sinking to your stop loss.
The second worst-case scenario would be the stock price sinking just below your stop loss, thus activating the sale of your position, before shooting upwards and blasting through your now-cancelled exit order.
There is a complex cousin of this risk-mitigation strategy called spreads. It involves option trading and provides a completely controlled risk-to-reward outcome.
Read more about them in our Options Pt. 4 Educational Piece.
Dividend Stocks
A Warren Buffet favorite.
Under certain market conditions, buying a dividend stock is a splendid example of an asymmetrical bet. However, even on its own, dividend stocks provide a rather obvious upside that most securities you likely hear about cannot offer.
They pay you for owning them.
A dividend stock’s price is relatively stable, with many thanks to their low beta. Although actual appreciation is not as fast as growth stocks, the dividend yield alone represents an increase in position, especially if reinvested and compounded. With limited downside, (usually) steady upside, and a bonus in the form of dividend payments, dividend stocks surely represent a bet in which the upside outweighs the downside.
Did you know? Beta means how much the stock moves in relation to the benchmark indices, such as the Dow Jones and the S&P500. If a stock tends to move .75% for every 1% the market’s indices, that equates to a .75 beta. Stocks under a 1 beta are deemed low-beta stocks and are good for when the economic cycle is in a contraction. This is what earns them the title of “defensive stocks”.
In those rare moments when you catch a dividend stock quoted below its book value, this essentially makes it an asymmetrical bet on steroids.
As dividend stocks tend to trade right at par value with their fundamentals, moments of irrational market fear may drop their valuation below their book value. During the COVID-19 pandemic, plenty of dividend stocks saw drops as large as 25%.
For some, that was scary; for value investors, they were foaming at the mouth.
Capturing a yield-bearing stock at a 25% discount to market provides an outstanding asymmetrical bet because of the high likelihood of it returning to market value.
When drops in share price occur with no major fundamental change or flaw in the company, the bullishness for a stock generally increases.
When a stock price drops 25%, it requires a 33% gain to return to its previous value.
An ambitious value investor may be comfortable deploying $1 million into such a stock, reaping a fairly quick $330,000 upside upon the 33% recovery to the previous valuation.
A 33% gain in less than a year is practically unheard of for dividend-paying, blue chip stocks. So, such opportunities make them quite the asymmetrical bet.
Depending on how much capital you are working with, plus your risk tolerance, any of these three strategies have the potential to be useful for your investing journey.
Trade with caution, do your research, and let us know how it goes.
Happy investing,
-Edge