*** Ahh, a new year has finally begun. So what will this year hold for us small-cap investors? Of course, it’s impossible to say right now. But based on ONE day of trading, it seems the rank-and-file public is a bit skeptical that the 2004 rally can continue.

The Russell 2000 dropped 11 points, from 651 to 640. That’s the single biggest drop since Dec. 7 — when it plunged 13 points. So is it time to run for cover…to hide the women and children?

Who knows, dear reader? I wouldn’t go that far. Crikey, it’s just one down day. If you look at a yearlong chart of the Russell 2000 or the S&P 600 (the two main small-cap indexes), we are still in a primary uptrend. And according to my colleague Carl Waynberg, this is usually a lucrative month for us small-cap investors.

Carl notes that…

“While the ‘January effect’ refers to the unusual bounce of equity returns for the market as a whole, the effect is particularly pronounced among small caps. The market Davids have outperformed the Goliaths in 61 of the 79 Januarys from 1926-2004, by an average of 1.5% per month. In 39 of the 61 years in which small caps outperformed big caps in January, they also outperformed for the year, by an annual average of approximately 5%. Small caps’ tendency to outperform big caps in January is even greater after a down year for the market.”

Hmmm…is there really something to this January effect? Is it truly a barometer for the rest of the year? Let’s look back at the last four years to see…

– In January 2004, the Russell 2000 rose 2.8% — outpacing the large caps, which only rose 1.8%. For the year, small caps rose 16%, versus just a 9% gain for the large caps. The January effect held true in 2004.

– In January 2003, the Russell 2000 fell 2.8% — lagging the S&P 500 by 0.1 points. But for the year, small-cap stocks ended up rising 42%, versus a gain of 22% for the large caps. Clearly, the January effect did not work in 2003.

– In January 2002, the Russell 2000 fell 1% — beating the S&P 500, which lost 1.5% for the month. And for the year, the January effect held true. Small-cap stocks lost 21% in 2002 — during the height of the bear market. And the large caps fell even harder — giving back 24%.

– Finally, in January 2001, the Russell 2000 rose a whopping 5.2%. Granted, it only ended up rising 6% for the entire year — but that was enough to beat its larger peers by a landslide. The S&P 500 only managed a 3.5% gain in January and went on to lose 11% for the year.

Well, there you have it. Over the last four years, the January effect has proved to be a sufficient barometer 75% of the time. We’ll see if it works this year. Stay tuned…

*** Of course, there is reason to be careful right now, my friends. It seems a lot of the “smart money” that was pouring into small-cap stocks during the end of last year may be funneling its way back out.

I got my daily note from Strategic Investment editor Dan Denning. According to Dan’s source, TrimTabs, “Equity ETFs began the year on Monday with an unexpected outflow of $604 million to accompany the decline in price. Small Cap was the leading redeemer of shares, losing $639 million.”

In other words…

On the first day of trading in 2005, major hedge funds and money managers yanked $639 million out of the Russell 2000. That’s exactly why the index fell 11 points yesterday.

I’ll be watching these numbers closely over the next few days, weeks and months. If the major players continue to take millions out of the small-cap market, beware…the rally could be in serious jeopardy. But…

Until the Russell 2000 breaks out of its primary uptrend, I’m not going to push the panic button. If you are a technical analysis guy or gal, keep an eye on two numbers…

If the Russell 2000 breaks below 636 and then 621, it may be time to sell. But until that happens, it’s business as usual. In fact, as I type, the small-cap index is back on the rebound — up 2.34 points.

Only time will tell.

Speaking of pushing the panic button, Irwin is about to get artsy on us…

The Art of the Small-Cap Pick

An underground art movement on Wall Street can actually help you identify the small-cap stars that generate profits of 70% and more. By marrying stock analysis with art appreciation, this emerging movement draws on the creative spark that can cause an unknown painting or a new product to make big money for the investors who discover them long before everyone else.

The movement has no official leader. It quietly grew out of several grass-roots initiatives whose mounting credibility has caught the attention of Wall Street. Although the brains behind the movement come from mutual funds, business schools and the art world, you can directly benefit from these mysterious experts through three key convergence points…which I’ll get to in a minute.

The adoption of a stock-like index to art sales started with NYU professors Jianping Mei and Michael Moses. Aptly called the Mei/Moses Fine Art Index, it determines the compound annual rate of return of art sold at auction since 1875 — and then compares that return against the S&P 500 large-cap stock index. Mei and Moses discovered that from 1953-2003, art appreciated by a compounded 12.06% annually…slightly ahead of the S&P 500’s gain of 11.65% for the same period.

With the art-stock link firmly established, your diligent Penny Sleuth went on to identify three convergence points between stock returns and art appreciation — cracking the code to finding the best small-cap investments.

And once you know about these three convergence points, your research is more likely than ever to turn up small-cap companies that deliver returns of 70% and more within 90-120 days.

The first convergence point is price. While the Mei/Moses Fine Art Index compares art with all stock styles, the similarities are strongest when we focus on small caps.

While the Russell 2000 small-cap index wasn’t around in 1953, as of mid-December 2004, its 10-year return from 1994-2004 was 12.07% — or one-tenth of a percent higher than what the Mei/Moses index registered for art. So overall, both art and small-cap stocks delivered higher returns than large-cap stocks.

Most recently, 2004 was a banner year for art collectors and small-cap investors. The Russell 2000 hit an all-time high of 656.11 on Dec. 31…while art prices last year rebounded from the speculative crash of 1990 to give investors an impressive return of 24.4%, according to Artprice.com.

This brings us to the second convergence point. It compares the most expensive, time-proven masterpieces with large-cap stocks. As institutions in their own right, both have blue chip reputations, unassailable quality and snob appeal. Rembrandt’s “Jan Six” is worth about $150 million, Gauguin’s “Bathers” is valued at $35 million and Picasso’s “Le Reve” was purchased in 2000 for $60 million.

While these prices would give the average small-cap investor a severe migraine, Mei and Moses actually found that masterpieces tend to appreciate less over time than new art — the same comparison applying to large-cap versus small-cap stock prices.

For example, while Travelzoo saw its stock jump about 1,000% in 2004, the idea of that happening to General Motors is absurd. That’s one reason why the S&P 500 was up only 9% in 2004 compared to the small-cap S&P 600, which soared 21.6%.

This leads us to our third and most important convergence point: small-cap stocks and modern art.

As part of its 2004 survey, Artprice.com determined that some of the biggest art world winners included American abstraction (85%), pop art (123%) and contemporary photography (57%) — all of which fall under the purview of modern art.

David Galenson, a professor of economics at the University of Chicago, weighs in with his observation that the highest profits in modern art are often realized when the artist has a breakthrough idea.

Of course, breakthrough ideas are the domain of small-cap companies. Extraordinary creativity drives a small-cap company to solve problems often ignored by established large-cap behemoths.

For proof, turn to a 2002 study from the Small Business Administration. It concluded that small companies produce far more patents than large companies. The study, conducted by CHI Research, substantiated small-company patent dominance by industry segment and other criteria — proving beyond a shadow of a doubt how much creativity comes from industrious dynamos with 500 employees or less.

Some of these numbers are downright amazing. In biotech, 71% of small companies held patents, compared to 45% of big companies. In pharmaceuticals, the numbers were 68% and 59%.

This single-minded drive to produce breakthrough products and services isn’t confined to the lab-coat set. It dominates all sectors of the small-cap universe. That’s one reason the Russell 2000 recently increased the frequency of adding newly public companies to the index from annually to quarterly.

In reviewing the 37 IPOs that entered the Russell 2000 effective Dec. 17, 2004, three of them stand out as industry breakthroughs…whose extraordinary creativity was rewarded by Wall Street with inspired stock hikes.

In the true creative spirit, Build-A-Bear Workshop, Inc. is the first national retail chain to let kids build their own stuffed animals. The company went public on Oct. 27, 2004, at $20, and as of 9:59 a.m. today, the stock was trading at $34.10 — for a warm and fuzzy 70.5% increase.

FoxHollow Technologies, Inc. manufactures and sells medical devices primarily for the treatment of peripheral artery disease. The ingenious Ph.D.s and engineers at FoxHollow developed a family of products that can eliminate invasive surgery for arterial plaque…the accumulating substance that causes strokes, heart attacks and death. FoxHollow started trading on Oct. 27, 2004, for $14. At 10:02 a.m. today, it was up a torrential 71.4%, to $24.

Biotech star IntraLase Corp. started trading on Oct. 13, 2004, for $13. IntraLase invented a better way to conduct LASIK eye surgery by replacing human intervention with a software “robot” that guides a critical metal blade. As of 10:03 a.m. today, its stock was trading at $23.34 — up an eye-popping 79.5%.

These ingenious small-cap companies that deliver gains of 70% and more are not found by accident. Investors who got in early recognized the world-class creativity that fuels rapid growth. So if you also want to pocket huge profits in small-cap investing, make sure your research turns up patents, creativity and a management team that knows the art of bringing unique ideas to market.

In finding the great creative companies, the price-to-research ratio will help determine if management is dumping its money into a black hole. You can easily figure out the PRR by dividing the market cap by R&D expenditures. If the outcome is 1-3%, that’s OK. If it’s bigger, you should double-check other fundamentals before investing a single penny.

But innovative retailers like Build-A-Bear obviously don’t have big R&D outlays. Instead, check their return on equity. In the case of Build-A-Bear, the company’s ROE of 36.1% is extremely impressive — clearly demonstrating that it can efficiently market its own visionary products.

The other thing to examine is top-line revenues. If the marketplace does not buy into a company’s innovation, it’s worthless. Companies such as FoxHollow and IntraLase saw their creativity validated by huge growth for their third-quarter 2004 revenues.

And regarding management track records, it’s important that the team is experienced in launching new companies and taking them public. Big-company types can often bring too much “baggage” to a small organization — making it inefficient. The results are higher overhead and go-to-market bottlenecks. You want the CEO to cut their small-company teeth someplace else.

Breakthrough creativity can be hard to find. But that’s the reason you can make a bundle on it thanks to small-cap innovators.

Happy investing,

Irwin Greenstein

January 04, 2005

The Art of the Small-Cap Pick was originally featured in the Penny Sleuth.