Small-Cap vs. Large-Cap Returns in 2007
Jan 22nd, 2007 | By Greg Guenthner | Category: Investing StrategiesAn Associated Press headline caught my eye early this morning. It read “Signs Point to Good Year for Investing in Large-Cap Stocks.”
I couldn’t help but wonder what signs these people are reading…
The gist of the article is that it might be time for small-cap investors to rethink their investment strategy. The author thinks that this year, the best bet for anyone with a dime in his pocket will be the big-name stocks that can ride out any bumps in the economy.
You see, his logic is that eventually, large-cap, blue chip returns must have a special year where they whip the Russell 2000’s returns. I’m sure some are eagerly anticipating this event as if it will somehow restore order to the stock market and promote world peace.
But as much as we humans enjoy synchronizing our watches and measuring significant events by calendar year, we tend to miss out on the bigger picture attempting to predict the unpredictable. Take, for instance, the AP article. The initial question posed is whether an investor should alter his strategy to focus on larger stocks since they are “poised to outperform” smaller ones.
The article states that the Russell 2000 posted a gain of more than 18% for 2006, officially beating the Russell 1000 Large-Cap Index for seven of the last eight years. However, the Russell 1000 caught a second wind and romped the 2000 for the second half of 2006.
So all of those investors who have been biding their time and are now claiming this is the year of the large-cap might have missed the boat. Ever since the Russell 2000 took a hit in May 2006, a lot of money has been flowing into large-cap stocks. The Dow Jones Industrial has soared while the Russell 2000 and the NASDAQ have lagged behind. Just look at the chart below:
Now we have the Dow squeaking out record highs seemingly every week. The Wall Street Journal reports that the Dow has posted 25 record closes since October 3.
So what are investors to do?
Well, there is a group of small-caps that are very attractive, but you must be selective…
A few months ago, our former value guru James Boric wrote that average investors are, in fact, buying garbage stocks, even in the small-cap arena. He determined this two ways:
The first, he searched for all small-cap companies traded on the NYSE at the 15 times earnings level or less, 1.5 times book value or less, 1.5 times sales or less, with positive free cash flow, revenue growth, and net income growth. This group would represent attractive small-cap value stocks. James watched as this group only appreciated 6.1% over the prior year — not much at all…
These stocks with good fundamentals are what investors should be clamoring for.
But it was another group of stocks that got all the attention…
The second group James followed were small caps on the NYSE that had negligible sales growth, no free cash flow, were trading at two times book value or more and had no earnings to speak of. The 19 stocks that made this list climbed 51% over the previous year as James watched…
Do you think that these stocks with rotten fundamentals will continue to rise? Well, we can’t tell you when they will stop, but we can tell you where we’d put our money.
Don’t get caught chasing the big returns, even if you are a devoted small-cap investor. We’ll be bringing you some of best plays on the small-cap market in upcoming issues of The Sleuth.
Best,
Greg Guenthner
January 22, 2007
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