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 most when the market's trajectory reverses direction.

Size matters
My colleague Tim Hanson writes that the best stocks of the past decade -- Hansen Natural (Nasdaq: HANS  ) , Asta Funding (Nasdaq: ASFI  ) , and Celgene (Nasdaq: CELG  ) -- all began as small caps.

What's more, my colleagues John Reeves and Ilan Moscovitz determined that small caps like Intuitive Surgical (Nasdaq: ISRG  ) , Terra Industries (NYSE: TRA  ) , and Guess? (NYSE: GES  ) were among the best-performing stocks since the last recession.

So regardless of whether we're entering into, already in, or emerging from a recession, 10 years from now, it's likely that 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 (stocks with market capitalizations under $300 million). This means that at the time, they were:

  • Very small.
  • Somewhat obscure.
  • Almost entirely ignored by 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 onto the success stories until they've moved out of this micro-cap phase, you've got 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 (Nasdaq: WINS  ) , 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% last month ... 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.

Fool analyst Adam J. Wiederman knows it all comes down to size, and is making the most of today's market opportunities. He owns shares of Intuitive Surgical, but not of any other company mentioned. Intuitive Surgical is a Rule Breakers recommendation. The Motley Fool's disclosure policy can be read here.


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  • Report this Comment On April 20, 2008, at 12:12 PM, phylo123 wrote:

    This article should be labeled "Advertisement".

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    I am a Motley Fool STOCK ADVISOR subscriber, and I feel it is entirely inappropriate to receive an e-mail entitled "Best stocks to profit from the drop" and then click on "Fool Watch Weekly" and realize that I have been hustled into reading an advertisement to subscribe to "Motley Fool Hidden Gems"

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  • Report this Comment On April 25, 2008, at 4:40 AM, dhkchan wrote:

    My sentiments exactly.....after subscribing to Inside Value and stock advisor, I feel disappointed that I get directed to Hidden Gems and need to subscribe to that in order to get some tips on what to invest in

  • Report this Comment On April 27, 2008, at 5:10 PM, srjewett wrote:

    The writers at fool.com get paid from someone, that someone needs to make a profit, or there is no pay for the writers. Free advice is worth what you pay for it. Case in point: Some writer ( not fool com) was selling what he/her call "Levarged Exchange Traded Funds". If you want to bet the "Come Line" why not just throw your money in the trash and save your time, when looking for an investment.

  • Report this Comment On April 29, 2008, at 9:55 AM, fasscash wrote:

    I agree with Will Romanoff and dhkchan

    Most of us have limited time to check email do what we do on the computer and then get your emails which do us no good unless we subscribe to THAT NEWSLETTER I am an II subscriber and am getting a little annoyed with them too

    fasscash

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    I think after using MFool sites you should know what is going on. They are in business and they will advertise.

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