(ISRG) MarketWatch is Wrong – The Case For Investing in Small Caps

Earlier this week, MarketWatch railed against investing in small-cap stocks.

And not just some small column buried in a deep, dark place on their website either… it was a feature article.

It states that investors might be “tempted to chase small-caps’ hot returns, be careful not to hop the last car of the train… small caps probably have seen their best days in this rally.”

Thanks for the oh-so prescient call, fellas. But why the heck should we believe you?

After all, I don’t recall you ringing the dinner bell to chow down on small caps in November 2008, December 2008, or January 2009, like I did.

Okay, enough of the self-promotion. But if the MarketWatch folks couldn’t spot the bottom back then, what makes them so sure they can predict the top now?

Yet there they are with their shamelessly bold article – “The Case Against Buying Small Caps Now.”

Let’s hit the courtroom and offer a legitimate rebuttal… with evidence that proves why now is still an attractive time to invest in small caps. Even better, I’ll share five easy tips to find the most compelling small-cap stocks in any market…

Hey, MarketWatch… Stick With the Facts, Not Opinions

~ Strike 1 Against MarketWatch: The article states that small-cap stocks have risen too far, too fast. Or as the publication puts it, “They’ve made a ton of money in a short time.”

But this is a hackneyed idea.

Need I remind you that this is exactly what everyone said about the current bull market in April last year. And that was after a mere 20% rebound off the bottom.

As you know now, they were dead wrong, providing yet another shining example of the checkered accuracy of the “too far, too fast” argument.

Small caps always trounce large caps coming out of a recession. Okay… not quite always. But 90% of the time, according to Standard & Poor’s, is close enough.

What’s more, this outperformance endures. For at least three years. And even up to 10 years, like it did following the nasty 1973-1974 recession.

So instead of investing based on a subjective assessment of how far is “too far” and how fast is “too fast,” I’ll stick with the hard data, thanks.

And it suggests that the small-cap rally could last for at least another two years.

The Trend isn’t Your Friend, Anymore

~ Strike 2 Against MarketWatch: “The trend is your friend,” right?

Well, not according to MarketWatch. It says this old Wall Street adage no longer applies because small caps have performed too well for too long.

As one of the experts quoted in the article states: “Small caps have led for nine out of the last 10 years… Prior cycle leaders are never the new cycle leaders.”

But the article offers no proof to back up this “never” claim. Instead, we get a bold prediction from investment manager GMO, which forecasts that returns for small-cap stocks over the next seven years will average less than 1% annually.

Really? Apparently, GMO has one powerful crystal ball. (Mine only sees two years into the future.) Not only that, it completely discounts the historical average annual small-cap returns of almost 13%, based on Ibbotson data.

I’m not about to take such a mighty leap of faith and bank on small caps performing completely out of sync with their long-term averages. Why? Because small-cap outperformance isn’t a trend… it’s fact. But one that MarketWatch fails to note.

The latest study from Bank of America Securities-Merrill Lynch found that small caps are the best asset class to invest in. Anytime. Period.

As Chief Investment Strategist, Richard Bernstein, summed it up: “Small-cap stocks offered the best risk-reward potential, regardless of time horizon” for the past 40 years.

I wouldn’t bet against that trend ending anytime soon.

MarketWatch Says to Check Your IQ At the Door

~ Strike 3 Against MarketWatch: My biggest objection to MarketWatch’s article is this: It assumes the average investor is an idiot.

Throughout the piece, it keeps mentioning that the best-performing small caps have been low-quality companies that almost went belly up in 2008. Or “companies with little or no earnings and in weaker financial shape.”

It asserts that buying these companies now would be a recipe for disaster.

Well, duh, Captain Obvious! The last time I checked, nobody said, “Let me go find a small-cap stock with garbage fundamentals to buy.”

We’re informed investors. We know that any old small cap won’t cut it. But MarketWatch apparently doesn’t give us that much credit.

But forget them. And the experts they rode in on, especially Ed Yardeni. He would like us to believe that, “If you jump in [to small caps] now, you’re not getting any bargains.”

That’s categorically untrue.

If you’ve got $20, you can scoop up 102 bargains by buying the Dreman Contrarian Small-Cap Value Fund (DRSVX). The average small cap in the fund trades at a price-to-earnings (P/E) ratio of just 14. That’s a 33% discount to the long-term average P/E ratio for small caps.

In other words, they’re cheap.

That’s three strikes. MarketWatch… you’re out.

If you want to get your hands dirty and uncover individual small-cap gems, here are five easy tips to do so…

Five Tips to Profit From Small Caps

When it comes to small cap stocks, I recommend focusing on companies with these five characteristics:

#1: Little/No Debt:

Given the havoc that credit crisis wreaked and the countless bankruptcies that resulted as cheap financing vanished, it’s best to avoid companies that rely heavily on debt.

Instead, stick with small caps that have little (or no) debt.

Look for a debt-to-equity ratio below 0.3. This alone will narrow down your choices significantly. And it will also (dramatically) reduce your risk.

#2: Prefer Pioneers:

Companies can create products to compete in existing markets. Or they can create products that are so revolutionary and timely that they launch their own markets and trends.

The latter obviously positions the company, and in turn investors, to reap the most profits.

Think of firms like Intuitive Surgical (Nasdaq: ISRG), Google (Nasdaq: GOOG), even VMware (NYSE: VMW).

#3: Sustainable Competitive Advantage:

We’re not looking for one-hit wonders. We want small caps that will become mid caps and eventually, large caps.

But to do so, it requires a sustainable competitive advantage – whether that’s through revolutionary products, an insurmountable first-mover advantage, or extremely high barriers to entry.

Anything that protects the underlying business from competition and enables the company to do the most important thing of all – increase earnings by a healthy double-digit rate.

#4: Within Three Years of an IPO (or Major Index Listing):

Smaller and/or newer companies have more room to grow. Plus, Wall Street tends to overlook many of these firms. By focusing on these young and virgin opportunities, we can actually profit ahead of the Wall Street institutions and the trillions in capital they control.

#5: Earnings… Earnings… and More Earnings:

Share prices ultimately follow earnings. By focusing on companies with the strongest growth profiles, we set ourselves up for the most dramatic gains.

Enough With the Small-Cap Bashing

Despite what the mainstream financial press would like you to believe, it’s possible to profit from small caps in any environment.

I hope you find these tips helpful. They’re just a small sample of the criteria that we use at The White Cap Report to select small-cap stocks for our portfolio.

Members of The White Cap Nation just locked in an 88% stock gain in Acme Packet (Nasdaq: APKT). And we’re getting set to release our May issue on Monday, with another under the radar, small-cap stock that has equally strong promise.

Good (small-cap) investing,

Louis Basenese

View original at: Investment U

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