It’s Small-Stock Sweet Spot Time!

By: Sy_Harding

Some investing truisms are pure baloney. For instance, that you can rely on the stock market returning 10% to 12% per year on average. That if you want higher profits you have to take more risk. That you can’t time the market. That election years are always positive for the stock market.

But there are some that can be very useful. The market is almost always higher in April than in September (annual seasonality). The market performs significantly better with a Democrat in the White House (so says the data of the last 100 years). The market tends to experience most of its serious corrections in the first two years of a new President’s term (and if it doesn’t, watch out in year three or four).

One that is about to enter its zone is the tendency for small stocks to outperform the market from mid-December to mid-January.

It used to be known as the ‘January effect’, but in recent years the pattern has tended to begin in mid-December. The theory behind it is that there’s a considerable amount of tax-loss selling in small stocks toward year end, which drives their prices down, and sets them up for bargain hunters. The tendency is for small stocks to often continue to outperform larger stocks into the spring.

One that I like is MTS Systems, symbol MTSC, Nasdaq, $40.25, small cap (15,800,000 shares). The company provides systems for testing and examining the mechanical behavior of materials, products and structures, as well as instrumentation for factory automation. The company’s sales and earnings slid significantly in the recession, but have been roaring back this year. Earnings over the last four quarters more than doubled on a 20% sales increase. The company is experiencing solid backlog growth, which bodes well for next year. Meanwhile, solid cash flow has allowed the company to increase its dividend, as well as to accelerate a share repurchase plan. MTSC has roughly $100 million in cash and no long-term debt, and sells at just 12.5 times trailing earnings.

I also like Neenah Paper Inc., symbol NP, NYSE, $20.32, small cap (15,600,000 shares). Neenah was spun off from Kimberley Clark in 2004. The company produces specialty paper products for filtration, abrasives, wall coverings, and melt-blown technologies, as well as for packaging and labels. Earnings are growing at double digits as the company builds on its growing export sales to Asia and South America. The shares are selling at 11 times trailing earnings with a dividend yield of 2.1%.  

Keep in mind that there are three risks in investing; market risk (the direction of the overall market), sector risk (the direction of individual sectors within the overall market), and stock risk (the direction of individual stocks within a sector).

And there’s more risk in small cap stocks because of their smaller float of available shares. The smaller float creates bigger gains in rallies when buying pressure dominates and there are fewer stock-holders willing to sell, but larger declines if unexpected negative news brings in selling pressure, since there are fewer bargain hunters aware of the stock and looking to buy.

One way to substantially decrease individual stock risk is obviously to diversify among numerous small cap stocks, and the easiest way to accomplish that is via etf’s designed to track with a small stock index.

So investors interested in the potential for extra dynamism in small cap stocks might want to consider that route.

Available small cap etf’s include the iShares S&P Small Cap 600 etf, symbol IJR; iShares Russell 2000 Small Cap etf, symbol IWM; and the Vanguard Small Cap Growth etf, symbol VBK.

Some investors object to investing in an index on the theory that if they can pick the best performing stocks within the index they can outperform the index.

Those willing to take the extra risk of individual stocks in an effort to beat the performance of the underlying index, might want to consider using a leveraged etf on the index instead. The advantage of diversification is still achieved, and a two-to-one leveraged etf will double the performance of the index while still avoiding the risk in the individual stocks.

One of my favorites in that category is the 2 to 1 leveraged ProShares Ultra Russell 2000 etf, symbol UWM.

Just be sure to keep in mind that leverage is a two-edged sword. Leveraged holdings produce gains much faster if you have the direction right, but also produce losses faster when you’re wrong.

In the interest of full disclosure, I and my subscribers have positions in one or more of the holdings mentioned in this column.

Sy Harding is president of Asset Management Research Corp., and editor of the free market blog Street Smart Post.

© 2011 Copyright Sy Harding- All Rights Reserved

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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