These Stocks Are the New Strong Buys

The title to this article is a snowclone. And while many of you don't know (yet) what a snowclone is, I believe the entertainment value of knowing a little about them almost matches the value of knowing which group of stocks has historically smashed the market's averages. Before I wander off on my tangent, you want to know about the new strong buys.

What's old is new again, because here in mid-2008, the new strong buys are the ones that have also historically bested the broader market by about 5% per year. That's always a good start, but today there's an added bonus -- these "strong buys" are coming off consecutive years of significant underperformance. Small-cap value stocks are priced better today than they have been for years.

I love the smell of small-cap value in the morning (it's the smell of victory)
According to Wikipedia, "A snowclone is a type of cliche and phrasal template originally defined as 'a multi-use, customizable, instantly recognizable, time-worn, quoted or misquoted phrase or sentence that can be used in an entirely open array of different jokey variants by lazy journalists and writers.'"

(Did somebody just call my name?)

The term "snowclones" originates from one of the lesser-known timeworn cliched templates, "If the Eskimos have N words for snow, the X surely have M words for Y." For instance: "If the Eskimos have 300 words for snow, Wall Street financiers must have 600 words for subprime mortgage derivatives."

It turns out that the Eskimos don't have a particularly large number of words for snow. (Wall Street does have several dozen terms for subprime mortgage products, although because of the number of layoffs of Wall Street's finest, most of these are unprintable in a decent public forum. But I digress.)

You might have used other snowclones, such as "Got X [milk]?" Or perhaps: "(Dammit, Jim,) I'm a doctor, not an [X]." Or even: "I'm not an [X], but I play one on TV." So in a move that will surprise nobody more than my editors (hey guys, I finally came up with my own subheads!), I've lazily inserted some classic snowclones below as phrasal templates to illuminate a few reasons behind small-cap value stocks' market dominance, and current strong positioning.

Give me your poor, your tired, your small-cap value stocks
In one of my favorite articles, "70 Times Better than the Next Microsoft," I recounted why small-cap value stocks crush the other quadrants of the market, large value, large growth, and especially small growth, over time. It's mostly because small value stocks are unexciting, spat upon, and ignored. They're the type of companies that seem painfully outdated, quaint, poor (tired, even) compared to the exciting tech stocks, biotechs, and other sectors that end up getting bid up to the moon -- and consequently disappoint the majority of investors. And yet, the returns are stunning. Here's one of my favorite tables proving the point:

Sector

Annual Returns, 1927-2005

Large-Cap Growth

9.54%

Large-Cap Value

12.37%

Small-Cap Growth

9.22%

Small-Cap Value

15.37%

Total Stock Market

10.01%

The most dramatic example this year is the way coal stocks like Westmoreland Coal (NYSE: WLB  ) , Alpha Natural Resources (NYSE: ANR  ) , and James River Coal have taken off, moving up 50% to 200% or more year to date. James River has done so with a fraction of the attention sexier companies garner. Think of the nonstop headlines for less stodgy alternative energy companies such as First Solar (Nasdaq: FSLR  ) and Suntech Power (NYSE: STP  ) .

Small-cap value is the new black -- and the new strong buys
When something is anointed the "new black," it is so hot and trendy that it will replace the old guard. The new black will be the color everyone will wear. Well, at least until the next "new black." Nothing ever really does replace black, but this construction is an attempt to promote something of the moment.

The highest compliment you can give to a stock in some corners is to say it is a "strong buy." But you know what? Small-cap value stocks are virtually never given Wall Street's official imprimatur as strong buys. The lack of such ratings keeps small value stocks at far better prices than the highly followed and touted large caps that do get dozens of strong buy ratings from the Street. Never being "the new black" or "strong buys" has provided small-cap value stocks' actual investors with great entry points for their money.

Though small-cap value stocks are dramatically underfollowed on Wall Street, numerous studies and reports argue that they have the best returns. Combine that fact with the particularly attractive prices at which these stocks are trading today, and you're looking at something far better than "the new black" or a "strong buy." You're looking at the antithesis of trendy: boring companies with boring returns over the past two years. These are precisely the companies that tend to dramatically beat the market over the long term -- especially after dry periods like the one we've just witnessed.

There's no crying in small-cap value!
Small-cap value doesn't beat the market average every year; its performance in the past two and a half years or so has alternated between "desultory" and "painful." Some of that underperformance results from the performance of financial companies, which comprise a large chunk of the value indices. However badly large caps such as Wachovia (NYSE: WB  ) and Bank of America (NYSE: BAC  ) have performed, small-cap regional banks like Cascade Bancorp and Great Southern Bancorp (Nasdaq: GSBC  ) have followed suit.

But you won't see us crying about that at Motley Fool Hidden Gems. The prices and opportunities that are available in small-cap value, particularly outside of financials, haven't been seen for at least four years, and probably closer to six.

For more on snowclones, check out the page on Wikipedia. For more on small-cap value, including what we're recommending right now at Hidden Gems (where we're beating the market averages by 20 percentage points over the past five years), take a free 30-day trial.

This article was first published May 27, 2008. It has been updated.

Bill Barker loves snowclones, but is scared of snowclowns. Bill does not own shares of any company mentioned here. Bank of America is a Motley Fool Income Investor recommendation. Suntech Power is a Rule Breakers selection. The Fool's disclosure policy is outlined here.


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