*** Small-cap stocks are kicking the crap out of the Wall Street darlings. And I don’t just mean a light beating, either. This is the kind of beating I used to give my little brother in wiffle ball tournaments when we were kids…when I was still a foot taller and infinitely stronger. I remember the days well…

I used to pretend every game we played was the seventh game of the World Series. I was the Cincinnati Reds (my favorite team). And my brother was the Chicago Cubs (his favorite team).

Sure, two National League teams could never meet in the World Series. But we didn’t care.

Every time I stepped to the plate, I waggled my bat like my home run idol — Eric Davis. And nine times out of 10, I hit a four-bagger. It was the most impressive streak never to be reported on ESPN.

By the time the game was over, I always came out on top — and not just by a run or two. These were 20-point bashings. My brother didn’t stand a chance. Although he was only 18 months younger, that’s a lot when you are 8 and he is 6.

It seems small-cap stocks have similar momentum on their side this year. The poor old large-caps simply don’t stand a chance.

*** As I type, the blue chip index is at 10,705 — less than 90 points off its high for the year. Not bad. The Nasdaq is doing even better — trading just 25 points off its 2004 high of 2,171. That’s worthy of an honorable mention. But the Russell 2000 is still leading the pack. And folks, it is NOT gonna be caught.

The day after the Fed met and raised rates by another quarter of a point, the Russell 2000 recorded a new all-time high of 648.61. It seems even higher rates can’t stop the end-of-the-year celebration going on.

Let’s check the box score for a second…

The Dow is up 2.4% in 2004. Not bad. The Nasdaq is up 6.7% for the year. That’s worth an honorable mention. And the Russell 2000 is up 15% for the year.

I love it. Small-caps are ahead by more than a 2-to-1 margin.

But eventually, the gap between the large cap and the small caps has to lessen…maybe even reverse altogether…right? I mean, my younger brother grew up to be taller, stronger and better looking than I. He could probably kick my butt in any sport known to man now.

So will the same happen in the battle between small- and large-cap stocks?

Who knows, dear reader? It could. You can’t expect to go out there and hit a home run all the time. You have to prepare for each game. You have to do your homework — looking at valuable stats like sales and net income growth, margins, cash reserves, value ratios and insider buying. You have to try to avoid the stocks that have had tremendous run-up with little in the way of fundamentals. And you have to be patient.

There are thousands of small-cap stocks on the market. In fact, of the 8,757 stocks tracked by Multexnet.com, 6,727 are small-cap stocks with a market cap of $1 billion or less. By my calculations, that means that 76% of all stocks on the market are small caps. That also means there will ALWAYS be opportunities to find a true bargain — even when the market isn’t so frisky. In fact…

I read an article this morning by Christopher Davis of Morningstar. He made a great point about the recent small-cap rally. Check it out…

“Just because small caps are generally pricey, though, doesn’t mean that there aren’t any good deals left. In fact, there are several thousand small-cap stocks out there, and most don’t get much in the way of attention from Wall Street. So even if the major small-cap indexes go nowhere in the years ahead, there’s still a decent possibility of unearthing underappreciated gems. Finding them won’t be as easy as it might have been a few years ago, of course. The small caps that have come up in our recent conversations with fund mangers have been tiny, beaten-down companies with very little analyst coverage.”

I couldn’t agree more. Because small-cap stocks don’t get analyst coverage, they tend to remain hidden — and cheap. But eventually, a good company (a growing company with viable products or services) will rise. Eventually, it will be covered by the major research firms. And eventually, it will become a mid- or large-cap stock. If you are willing to get in when no one else is, you can enjoy the rise…and make some serious money in the process.

Right now, it’s easy to be a small-cap investor. Everything is rising. But that won’t always be the case. Right?

Well, based on some research my partner in crime has unearthed, this small-cap rally may be far from over. Heck, it could go on for another 20 years or more.

Irwin, explain yourself…

A 26-Year Small-Cap Rally

Forget all the rhetoric about the current small-cap rally coming to an end any day now. Because a brilliant Yale professor who has already turned Wall Street on its ear has been quietly predicting a 26-year small-cap rally with lots of life left in it. The implications of his forecast may not be what you want to hear about investing, but this long-term strategy could set you up with a cushy retirement.

Contrary to the bombastic, self-serving sensationalism of the mainstream media, an unassuming professor at the Yale School of Management named Roger Ibbotson expects the small-cap rally that he identified as starting in 1999 to continue through 2025. Put another way, there’s 21 years left to this small-cap romp.

But the question you have to ask yourself is…

Would you rather buy and hold for a potentially huge return or simply follow the pack of small-cap speculators in pursuit of a quick buck?

If you believe in the long-term potential of small-cap investing, then please continue reading. Otherwise, I suggest you tune into that yapping hyena James Cramer.

That’s because Ibbotson’s thinking about the duration of the small-cap rally contradicts the herd mentality of many so-called experts, who insist that a shorter term small-cap rally that they say started in 1998…is on its last legs.

We don’t want to quibble between their 1998 start and Ibbotson’s 1999 start. But compared to Ibbotson, none of those blowhards has set the standard for Wall Street research — and in turn, given a historic context to small-cap stocks that has become the benchmark for serious investors.

Ibbotson is chairman of Ibbotson Associates, an international asset allocation consultancy that he started in 1997. In 1999, the good professor sent shock waves through Wall Street by blasting apart the old-boy creed that blue chips are the best way to make money on the stock market. His company published a revolutionary tract titled “Small Stocks vs. Large: It’s How Long You Hold That Counts.”  It proved, through rigorous research, that from 1926-1996, small caps beat large caps…hands down.

For example…

The study’s scrupulous research showed that the average 40-year accumulation for large-cap stocks is $15.95 — meaning that $1 would turn into almost $16. But get this: A $1 investment in a small-cap stock would have returned $60.63 during the same period. That’s a gain of ONLY 280.1% over the large-cap norm.

Today, you cannot open an important book or read a solid article about small-cap stocks without a reference to Ibbotson’s incredible insights. Well, Ibbotson goes even further with a lesser-known piece of research that once again refutes the large-cap urban legend.

In particular, conventional wisdom boasts that the current small-cap rally, which popular opinion says started in 1998, is entering its sixth year. Of course, this has Wall Street worried, because it supports the notion that small-cap stocks have a run of only 5-7 years before they retreat. This conventional thinking means that the current rally is either overextended or near exhaustion.

After all, since the leading small-cap index, the Russell 2000, has surged nearly 50% this year (hitting an all-time high in the process) — compared to about a 30% gain for the large-cap S&P 500 – a day of reckoning must be close at hand. The gods of Wall Street wouldn’t have it any other way.

Why not?

Their school of thinking conveniently exploits a common myth about small-cap stocks: that they are purely speculative…or in other words small caps are OK for a one-night stand, but if you want to marry the right kind of equity, you definitely hang out at the snooty S&P 500 club — not on the Russell 2000.

But backed by a rich historical perspective, Ibbotson and his associates insist that 1999 was just the beginning of a 26-year small-cap run that would once again beat the returns of the large-cap elitists. Throughout the period 1999–2025, Ibbotson and company believe that small caps will yield a total return of 12.5%, versus 11.6% for large caps.

So now that you know this information, how do you capitalize on it?

Let’s refer back to Ibbotson’s revolutionary 1999 paper, since it provides us with a trading strategy that complements his more recent 26-year small-cap-rally scenario.

In 1999, Ibbotson found that small-cap investments BEAT large-cap investments 90% of the time after 18 years. And that success rate increases to 100% after 32 years.

If that sounds nutty, then all of us should be as nutty as Warren Buffett, Phil Fisher and T. Rowe Price, who amassed multibillion-dollar fortunes on long-term, small-cap investments.

So with the imminent arrival of 2005, we still have 21 years to buy the best possible stocks. Do your research, believe in your investment and then sit back.

Happy investing,

Irwin Greenstein

December 17, 2004

P.S. As a visionary, Ibbotson has consistently identified future investment trends by precisely placing them within a larger historical perspective.  Otherwise, what you get is the typical hot tip du jour that’s dished up by the talking heads and self-serving columnists who comprise the rank-and-file mass media.

But my gifted colleague Chris Mayer is editor of The Fleet Street Letter, which has been advising conservative investors for 67 years, giving him a finely honed historical context for future economic developments. Better yet, as a former investment banker who dealt with entrepreneurs on a daily basis, Chris can read the economic tea leaves better than anyone.

That’s why I wanted to let you know that Chris has just completed a very perceptive paper on seven stunning stock market predictions for 2005.  I know that, like Ibbotson, Chris has placed a lot of emphasis on continuity, integrity and dependability in terms of what 2005 holds in store for people who are serious about making money — safely.  So please take a few minutes to read Chris’ excellent report.

A 26-Year Small-Cap Rally was originally featured in the Penny Sleuth.