The Best Stocks to Profit From the Drop

Let me share a secret. You'd be hard-pressed to find it revealed anywhere else, and it's probably the last thought on your mind as the world's major indexes plummet.

So what's the secret?

Stocks will rise again.

Simple. Succinct. But true. And rather than sulk over lost value, we should prepare to profit from the current market conditions by plotting out which stocks will benefit the most when the market's trajectory reverses direction.

Size matters
My colleague Tim Hanson writes that the best stocks of the past decade -- Green Mountain Coffee Roasters (Nasdaq: GMCR  ) , Clean Harbors (Nasdaq: CLHB  ) , and Innodata Isogen (Nasdaq: INOD  ) -- were all small caps.

What's more, my colleagues John Reeves and Ilan Moscovitz determined that the best-performing stocks since the last recession were not stable large caps like Research In Motion (Nasdaq: RIMM  ) and Potash Corp. of Saskatchewan (NYSE: POT  ) , but mostly small caps like Range Resources (NYSE: RRC  ) .

So regardless of whether we're entering into, already in, or emerging from a recession, it's likely that 10 years from now, your investments in small-cap stocks will retrospectively be the ones you consider the most profitable. And the good news is that many of these stocks are currently cheap.

Think small ... very small
It's worth noting that nearly all of these small-cap outperformers were actually micro caps -- that is, stocks with market capitalizations of less than $300 million. This means that at the time, they were:

  • Very small.
  • Somewhat obscure.
  • Almost entirely ignored among investors and analysts.

It's this last point that's crucial: The best way to profit from investments in small companies is to discover the inevitable winners earlier than Wall Street does. And since Wall Street typically doesn't latch on to the success stories until they've moved out of this micro-cap phase, you have an inherent advantage over even the best money managers.

Now, to be honest, these stocks are much more volatile than most large-cap stocks. Take SM&A, a micro-cap company that helps government contractors bid for, win, and manage government contracts. We wrote about it in our Motley Fool Hidden Gems investment service recently because it has competitive advantages in its niche, generates lots of free cash flow, and was cheap. Yet it dropped 20% in March ... in one day.

Did that drop mean SM&A is suddenly an expensive stock with no free cash flow and no competitive advantages? Of course not. But when it comes to tiny companies, a jittery market won't stand for even a whiff of bad news.

Actionable advice
Given the potential for exaggerated price swings, if you can't handle volatility, micro- and small-cap stocks shouldn't make up the majority of your portfolio. And you shouldn't haphazardly invest in stocks simply because they have small market capitalizations. But the long-term rewards of investing in best-of-breed micro- and small-cap stocks will pay off handsomely. Even if you're wary, a 10% or so allocation to small caps can yield promising long-term profits.  

To take a look at the small, cheap companies (of both the small-cap and micro-cap variety) that we're following and recommending today, click here to try Hidden Gems free for 30 days.

This article was first published April 15, 2008. It has been updated.

Fool analyst Adam J. Wiederman knows that it all comes down to size and is making the most of today's market opportunities. However, he owns no shares of the companies mentioned above. The Motley Fool has a disclosure policy.


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