The Best Stocks for the Next 4 Years

Did I miss something, or did the market just bottom?

We can’t quite be sure just yet, but investors in Ford (NYSE: F  ) , Dow Chemical (NYSE: DOW  ) , American Express (NYSE: AXP  ) , and Aflac (NYSE: AFL  ) are likely convinced -- each of those stocks is up more than 50% over the past month!

But some analysts, like Nouriel Roubini, still predict that stocks have further to drop.

It's safe to say negativity still abounds
The late Sir John Templeton called scenarios like we’ve been in "points of maximum pessimism." He also taught that times of maximum pessimism are the best time to buy -- and he practiced what he preached.

When the Second World War began and stocks started to fall, he borrowed $10,000 and invested it in 104 companies whose shares were trading for less than $1 -- including 34 that were in bankruptcy. Four years later, he sold his positions for $40,000, booking a 300% gain on stocks the market thought were doomed.

With his example in mind, I believe the pessimism still lurking around continues to signal a buying opportunity.

Stocks to profit from pessimism
We should be buying stocks that, like Templeton's initial bet on pessimism, could become double- or triple-baggers in the four or so years coming out of this bear market.

We know the top stocks since the last recession began were mostly small caps -- albeit with a few mid-cap rock stars like Apple mixed in. Among other things, small companies can more quickly and efficiently cut costs and streamline operations than can larger companies with employees and resources scattered throughout the country and the world.

But what kinds of companies outperformed since the end of that bear market? I ran a screen to see what kinds of companies were double-, triple-, or even-better-baggers as the recession receded. And sure enough, the best-performing companies over the following four years were all small caps:

Company

4-Year Return
from Oct. 9, 2002

Oct. 9, 2002 Market Capitalization
(in millions)

AmericaTower

5,137%

$139

YFP

2,857%

$434

Research In Motion

2,422%

$705

Bancolombia

2,067%

$203

WESCO International

2,054%

$142

Corning

1,890%

$1,173

Crown Castle International

1,830%

$373

AES

1,767%

$597

Coldwater Creek

1,670%

$131

McDermott International

1,616%

$232

Data from Capital IQ, a division of Standard & Poor's.

This list merely shows the top 10, but it's also true that small caps as a whole outperformed their larger brethren coming out of the last bear market -- and this phenomenon wasn't unique to that situation. According to T. Rowe Price research, small-cap stocks led the market out of the past 10 recessions, posting an average 28% gain, versus the 19% gain for large caps in the year following the market's recovery.

Given this data, I also ran a screen to see which small caps are dirt cheap right now -- and possibly poised to outperform as the market recovers. I looked for companies down more than 50% over the past year, and trading with price-to-earnings ratios below both that of the S&P 500 and their five-year average -- qualities I believe could make for Templeton-sized gains over the next four years.

Here are three companies from that screen. These aren't formal recommendations, but they're a good place to begin some further research.

Company

Market Capitalization

P/E Ratio

Pengrowth Energy Trust (NYSE: PGH  )

$1.9 billion

4.7

Bucyrus International (Nasdaq: BUCY  )

$1.4 billion

6.0

CapitalSource (NYSE: CSE  )

$617 million

N/A

Data from Morningstar and Capital IQ, a division of Standard & Poor's.

All in the family
So if, like me, you're looking for the best stocks to carry your portfolio out of this bear market and into wealthy pastures in four years' time, you need to look for small, underfollowed companies like those above -- and like those we search for as additions to our Motley Fool Hidden Gems portfolio.

Hidden Gems is outperforming the market by more than eleven percentage points -- and every month, advisors Andy Cross and Seth Jayson add two new recommendations, as well as their best ideas for new money now. If you'd like more insight into the market's best small-cap stocks right now -- including ones we recommend -- try out the service with a 30-day free trial. Click here to get started -- there's no obligation to subscribe.

This article was originally published Sept. 5, 2008. It has been updated.

Adam J. Wiederman owns none of the stocks mentioned above. The Motley Fool owns shares of American Express and CapitalSource. American Express is an Inside Value recommendation. Aflac is a Stock Advisor recommendation. The Motley Fool's bold disclosure policy is here.


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