Small Caps and Cycles...

03/03/2006 12:00 am EST


James Oberweis

President, Oberweis Asset Management, Inc.

"Roman historian Tacitus first noted that in all things there is a law of cycles; in that regard, not much has changed in the last 2000 years," notes Jim Oberweis , who explains cycles in small-cap stocks, as well as offering a trio of small-cap favorites.

"Over the 1926-2004 period, small-company stocks have outperformed large-company stocks by a little more than 2% per year, on average. However, along the way there have been multi-year cyclical periods favoring small company stocks over large. From Dec 1973-July 1983, the stars were aligned for small-company stock investors. On average, small-stocks beat large-caps by 10.9% annually except for 1980, when both small-caps and large caps performed equally well.

"Satya Pradhuman, director of Small-Cap Research for Merrill Lynch, in his book Small-Cap Dynamics, points out that the single biggest long-term factor is economic growth. According to Pradhuman, smaller firms have greater economic sensitivity than large capsand thus tend to outperform large-caps when the economy experiences periods of rapid growth. To find a strong economy, look for sharply increasing industrial production.

"An appreciating dollar has historically correlated well with small-cap outperformance. Additionally, watch inflation. Inflation, per se, is not good for equities. In the short term, Pradhuman asserts that changes in market volatility should be closely observed. Periods of declining market volatility tend to favor small-cap stocks. Changes in market volatility affects the willingness of investors to assume risk; hence, when investor appetite for risk increases, small-caps tend to outperform.

"Predicting changes in the large-cap/small-cap cycle is challenging. One strategy is to simply remaining fully invested, pick good stocks, and accept the volatility of the cycles. Many, if not most, people try to emotionally guess (rather than fact analyze) the cycle and blow it. Many extrapolate the recent past and assume it will persist. Confidence tends to be highest when we approach the inflection point. When it seems like that either small-caps or large-caps will never come back into favor, it probably won’t be long before they do. Meanwhile, here are some of our current favorite small-cap issues, all of which may be appropriate for risk oriented investors:

"Retalix Ltd. (RTLX NASDAQ) provides integrated enterprise-wide software solutions to supermarkets, convenience stores, fuel stations, and quick service restaurants, as well as foodservice, grocery, convenience products, and fast moving consumer goods distribution organizations. These applications enable users to increase operating efficiencies, while improving customer acquisition, retention, and profitability. In the company’s latest reported third quarter, sales increased 55% to $52. while earnings grew 140% to $0.24. Clients of Oberweis Asset Management own 262,000 shares.

"Comarco (CMRO NASDAQ) is a leading provider of wireless test solutions, such as its ChargeSource universal mobile power products and wireless emergency call box systems. Its Seven.Five wireless test system applications allows cellular telephone system operators to improve the quality of their cellular service and its open architecture supports both current cellular operating system technologies and the new 3G systems being implemented all over the world. In the company’s latest reported third quarter, sales increased 103% to $13.6 while earnings grew to $0.08 v a def. in 3Q04. Our clients own 332,000 shares.

"GMX Resources (GMXR NASDAQ) is engaged in the exploration and production of natural gas and crude oil in Oklahoma, Louisiana, Texas, and New Mexico. About 93% of 2005 production was natural gas and 7% was crude oil. GMX has established a record capital expenditure budget of $93 million for 2006, and will drill 43 net wells versus the 13 net wells it drilled in 2005. Depending on the success of this drilling program, it’s possible that GMX Resources’ proved reserves will again increase substantially in 2006. In the company’s latest reported third quarter, sales increased 139% to $4.4 million. GMX reported earnings per share of $0.20 versus $.04 in the same quarter of last year. Our asset management clients own 311,000 shares."

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