Why You Should Expect Small-Caps to Shine (Again) in 2010

by Louis Basenese

Why You Should Expect Small-Caps to Shine (Again) in 2010

by Louis Basenese, Small Cap & Special Situations Expert

Thursday, January 7, 2010: Issue #1170

The well-documented, post-recession rally for small-caps is not a sprint. It's more of an endurance test, like a marathon.

But don't just take my word for it. Take a look at the hard data...

  • On average, small-caps outperform their large-cap neighbors for a full three years coming out of a recession, according to Morningstar.
  • Coming off particularly nasty slowdowns, small-caps boast even more endurance. For example, after the 1973-1974 recession, small-caps trounced large-caps for an entire decade, returning an average of 28% per year.

Based on these historical measuring sticks, you can see that the current small-cap rally isn't anywhere near an apex. It should continue for at least two more years - and potentially nine!

Note to Skeptics: Four Reasons Why Your Small-Cap Pessimism is Wrong

At this point, the skeptics in our midst might be tempted to shoot holes in my prediction, saying things like, "History doesn't always repeat itself." Or, "We need something more meaty than a few data points to prove that small-caps will lead the charge again."

Fair enough. So let me assure you that the fundamental case for a prolonged small-cap rally is just as sound. There are plenty of reasons why small-caps have performed best coming out of past recessions. And they ring true in today's market, too...

  • Innovation: Small companies don't care what is happening with the economy. They're constantly innovating anyway - a phenomenon that is substantiated by Scott D. Anthony and Leslie Feinzaig of the consulting firm Innosight. In contrast, research demonstrates that larger companies cut back on innovation during downturns.
  • Size: Because of their size, small-caps can adapt their strategies faster than bureaucracy-plagued behemoths during recessions. The result? Much more stable earnings. And a leaner, meaner organization poised to attack growth strategies once the economy picks back up.
  • Niche Markets: Most small-caps operate in under-penetrated industry niches, devoid of much competition. In other words, their profit opportunities are young... and unlimited.
  • Ignorant Wall Street: Most small-caps fly under the radar and scrutiny of Wall Street analysts. Consequently, management teams focus on long-term results, not unrealistic short-term expectations. In turn, their growth is more powerful and often undervalued... that is until it gets so strong analysts must pay attention. At that point, stock prices zoom to bridge the valuation disconnect.

If you're sold on the positive outlook for small-cap stocks in 2010, you need to understand an important point before you load up on them...

Why Now Is the Time to Invest In Small-Caps

After such an impressive run in 2009, we can no longer buy any old small-cap stock, or a passive index fund like the iShares Russell 200 Index (NYSE: IWM) and hang on for the ride. Not if we want to bag the highest returns.

That's simply because in addition to small-caps leading the pack, the historical record also indicates that the market follows another very predictable pattern...

Low-quality stocks - those that suffered the worst beating during the recession - rally first and the most. True to form, financials led the way off the March 9 bottom, rallying an average of 130%.

Eventually, though, investors wise up. And when they get back to putting a premium on fundamentals, they rotate into higher-quality companies (i.e. - value stocks) that got left behind.

Here's the good news: We can pinpoint the timing of this rotation. Based on research from RBC Capital Markets, it typically occurs about 10 months after the market hits bottom. That's this month!

So if we want to ride the small-cap rally for maximum gains, we should rotate into small-cap value stocks. Thankfully, it's an easy transition to make...

It's Prime Time for This Small-Cap All-Star Fund

In August of 2009 last year, I told you about David Dreman. Nobody is better at discovering small-cap value investments than him.

In fact, over the past five years, he's beaten the small-cap value index by an average of 7% per year. He's outperformed the index over the past decade, too.

And since I first mentioned his fund - the Dreman Contrarian Small Cap Value Fund (DRSVX) - it's up a tidy 18%, outperforming the S&P 500 over the same period.

But Dreman is just getting started. Thanks to a top-notch and stringent stock-filtering process, he consistently unearths the most undervalued, highest quality small-cap companies.

And right now, his portfolio is filled with 98 compelling opportunities, trading for an average price-to-earnings ratio of 11. That's a whopping 81% discount to the average stock in the S&P 500.

Clearly, as the small-cap rally continues and these stocks catch up with valuations, we've got plenty of upside. So what are you waiting for?

Good investing,

Louis Basenese

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