5 Stocks to Tap the Coming Rally

It's coming -- an all-out recovery.

I don't know when (and I don't think anyone else knows when, either), but it's coming. And that means it's time to invest in small-cap stocks.

History is repeating itself
During the last bear market -- when most stocks nosedived -- small-cap stocks absolutely soared, handing savvy investors 22% a year over the next three years.

Their amazing run during the 2001-2002 recession was no fluke. Starting in the middle of the brutal recession of 1974, small caps made an epic run. Shooting up during the recession and extending their run long after the economy recovered, they returned 28% a year for nearly a decade.

And beginning in 1991, small caps powered right through a sharp downturn and kept gaining -- handing investors 116% over three years. 

The best part of all of these bits of history? Small caps started their run smack in the middle of the bear market -- not after the turnaround. And that means right now is a great time to buy.

How to buy in
If you want to hedge your small-cap bets, you could hope to enjoy similar returns this time around by investing in a nice ETF like the iShares S&P SmallCap 600 or the Vanguard Small-Cap Value ETF.

But even that limits you. Instead, invest in the healthy, competitive companies that could use the coming rally to build unbelievable returns.

It's happened before. Each of the stocks in the chart below were small caps transformed into some of today's most well-known large caps:

Stock

Bear Market

Length of Small-Cap Rally

Gain

Hewlett-Packard (NYSE: HPQ  )

1974

9 years

340%

Cisco (Nasdaq: CSCO  )

1991

3 years

2,750%

Oracle (Nasdaq: ORCL  )

1991

3 years

642%

Data from Yahoo! Finance.

What opportunities might be awaiting investors this time around?

Small caps idling on the launch pad
Right now, an irrational fear of further economic collapse is pushing some of today's best small-cap stocks down to epic lows.

Just have a look at the companies below. Each has seen its stock price fall dramatically over the past year. Yet each has seen incredible net income growth over the past five years (a sign of a healthy company):

Stock

Market Cap

1-Year Price Change

5-Year Net Income Growth Rate

Diana Shipping (NYSE: DSX  )

$1.1 billion

(52%)

88%

Compuware (Nasdaq: CPWR  )

$1.8 billion

(29%)

23%

Big Lots (NYSE: BIG   )

$1.8 billion

(28%)

13%

Alpha Natural Resources (NYSE: ANR  )

$2.2 billion

(70%)

126%

CoStar

$716 million

(26%)

201%

Data from Google Finance.

While these are not formal recommendations, I find it hard to believe that these small, profitable companies will stay at prices this low for long. Now's the time to dive in and get greedy.

But aren't small caps risky?
It's true that small caps tend to be more volatile over the short term than their larger brethren. Small companies can also face more business risk than larger, more entrenched corporations. And sometimes it's far too easy to get caught up in the "story" and money-making "potential" of small caps.

For example, I dove in headfirst when I invested in Sirius XM Radio back in March 2008. I was too busy watching my shares rocket up after the merger to notice that the company was hemorrhaging hundreds of millions. My shares are currently down 85%.

Like every other investment, small caps require us to be selective and attentive -- because the truly healthy small companies will the lead the next bull market, and extend their gains for years to come.

Adding just a select few small companies to your portfolio can have a dramatic effect on your long-term wealth. And this is an incredible time to invest in small caps.

That's what the advisors at our Motley Fool Hidden Gems investing service are doing. They're investing $250,000 of The Motley Fool's money in the best small caps around. You can see all of their top picks free for 30 days -- just click here to get started. There's no obligation to subscribe.

Already subscribe to Hidden Gems? Log in here.

This article was originally published on June 17, 2009. It has been updated.

Ryan McLimans is holding his shares of Sirius indefinitely. The Motley Fool owns shares of the Vanguard Small-Cap Value Index. The Motley Fool has a disclosure policy.


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