Stay in the Market’s Sweetest Spot

01/13/2011 4:37 pm EST

Focus: MARKETS

Howard Gold

Founder & President, GoldenEgg Investing

Sell your losers and let your winners ride—that’s the advice many successful investors give their clients.

But first you need to know who the winners really are. Any guesses? Gold? Sure. Emerging market stocks and bonds? They have been until recently.

The biggest winner you probably haven’t heard of is US small-cap growth stocks. Yes, those darlings of the late 1990s have made a stunning comeback.

According to Callan Associates, the Russell 2000 growth index soared 29% in 2010, trailing gold by half a percentage point and beating real estate investment trusts by a full point.

In fact, this is the second consecutive year small-cap growth stocks have topped the charts: They outpaced all other domestic equity groups in 2009, with a 34.5% return.


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That’s not surprising: Small-cap growth stocks are usually one of the first movers in economic and market recoveries. They also topped the leader board in 2003, when the last recovery and cyclical bull market in stocks got started.

Small Recovers First

“Small stocks tend to do well in little bursts...after times of recession,” says Jay Kloepfer, director of capital market and alternatives research at Callan, a San Francisco-based investment consulting firm.

Its nifty Periodic Table of Investment Returns graphically captures the market’s big winners and losers each year. (Callan will post an up-to-date version on its website in coming weeks, but they were kind enough to share preliminary data with me for this column.)

Small-cap growth stocks generally comprise the fastest growing companies in the Russell 2000—the most widely used index of domestic smaller stocks. Their market capitalization—stock price times number of shares outstanding—generally ranges from $300 million to $2 billion. (Large-cap stocks have market values above $10 billion.)

Since small growth companies tend to be more economically sensitive than large blue chips, their stocks  react much more quickly to a change in the weather.

“The economy tends to lag and the market tends to lead,” says Kloepfer. It sure has this time.

Growth Finally Gets Its Due

Another reason for their huge gains the last two years: pent-up demand.

“Going into 2008, you had…the biggest bull market in small-cap value versus small-cap growth in [recent] history,” says Jim Oberweis, president of Oberweis Asset Management, a small-cap growth specialist based in Lisle, Illinois.

“From March 31, 2000 through the end of 2008, the Russell 2000 value index outperformed the Russell 2000 growth index by an astounding 1,253 basis points annualized,” he adds.

That means small value outdistanced small growth stocks by 12.5% a year for almost nine years.

Also, says Oberweis, the sell-off of small caps during the financial crisis was extreme. “You had an absolute collapse of risk appetite in 2008,” he observes. “In my career, I’d never seen anything like this.”

In those dark days, he scooped up small-cap growth stocks at single-digit price/earnings ratios and at share prices below the cash on the companies’ books.

Cheapskate value investor Ben Graham would have been delirious.

Next: Can they remain on top?

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But after two pace-setting years, can small-cap growth remain in the winner’s circle? Kloepfer is dubious.

“I’m not sure small-cap growth [out performance] can persist for more than a couple of years,” he says. “Either the small-cap companies graduate to large-cap companies or the market cycle [moves on].”

Acknowledging that small growth stocks’ periods of out performance are usually “concentrated,” Oberweis still thinks this time is different—mostly because they still have much room to catch up.

“Small-cap growth stocks remain undervalued relative to small value stocks. What you haven’t seen [yet] is a multiple expansion back to more normal levels or above-normal levels. We’re not even at average,” he says.

There's Still Some Upside

Oberweis says the stocks in his portfolio are trading at around 18x earnings, and the more “normal” range is 25x-26x.

But in previous cycles, these stocks have overshot that mark before the inevitable correction—usually accompanied by rabid hunger from the investing public. So far, retail investors have only begun to nibble.

We’ve seen some buying of US stock funds lately and a bit of a pickup of money flows into aggressive growth funds, he says, even though last year they handily outperformed emerging markets, 2009’s big winner.

So, although Oberweis concedes “the very sweet spot in the cycle is when the economy is emerging from recession,” he adds that “my gut [says] we’re still in the early stages.”

I agree, and I’ve put my money where my convictions are. I own Fidelity Stock Selector Small Cap (FDSCX) and Vanguard Small Cap Growth Index (VISGX), but as usual, they’re a small part of my portfolio. (Read about Fidelity and Vanguard’s “hot hands” small cap funds in Money Show.com here and here.)

Two exchange traded funds that track this sector well are Vanguard Small Cap Growth ETF (NYSEArca: VBK) and iShares Russell 2000 Growth Index ETF (NYSEArca: IWO). Both are pretty inexpensive, although the Vanguard is about 11 basis points (0.11%) cheaper.

And if you’re risk-tolerant enough to buy individual small growth stocks, Oberweis has a couple of recommendations.

Higher One Holdings (NYSE: ONE), which went public in June, provides banking services and electronic disbursement of student loans to students at US colleges and universities. Analysts estimate it earned 55 cents a share last year and that it will earn 72 cents in 2011, although Oberweis thinks it could top that. Revenue growth should be around 30%. It closed Wednesday above $19, less than 27x this year’s estimates and a little below its projected growth rate.

MIPS Technologies (Nasdaq: MIPS) makes chip sets for digital set-top boxes, but Oberweis thinks it has a promising future serving the wireless and smart phone market, currently dominated by the UK’s ARM Holdings plc (Nasdaq: ARMH). Wall Street expects MIPS to earn 52 cents a share in the fiscal year ending June and 60 cents in fiscal 2012. “If they launch a successful mobile application, those numbers will be a lot higher,” he says. At around $16.50, its multiple is higher than ONE’s and it looks more speculative to me.

In fact, the whole sector is pretty risky. According to Hulbert Interactive, the Oberweis Report, which ranked among last year’s top-performing newsletters, has a standard deviation (volatility) of monthly returns more than twice that of the broad Wilshire 5000 index.

Oberweis’s approach is particularly “high octane,” according to Morningstar, and his fund, Oberweis Aggressive Growth (OBEGX), racked up a 52% gain in 2009 but lost 57% in 2008.

Small-cap growth stocks are mostly for younger people who have lots of time to recover from the bad years or well-diversified, risk-tolerant investors who are savvy enough to get to the exits quickly when it looks like the game is up. And over the very long haul, of course, the research shows small-cap value is a much better bet.

Given those caveats, though, I think small growth stocks’ current move has a way to go, so I’m sticking with these unheralded winners for now.

Howard R. Gold is editor at large for MoneyShow.com and a columnist for MarketWatch.

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