You’d Be Stupid to Buy These Stocks

Now is an absolutely ridiculous time to buy small-cap stocks.

You'd be a dope to snap up shares of companies like AgFeed (Nasdaq: FEED  ) , Human Genome Sciences (Nasdaq: HGSI  ) , Cell Therapeutics (Nasdaq: CTIC  ) , and Conseco (NYSE: CNO  ) -- all of which are up more than 500% since March's market low.

Or at least, that's what you might be thinking, now that the small-cap Russell 2000 Index is outpacing the S&P 500 by more than 15 percentage points. Even The Wall Street Journal predicts that the small-cap rally is set to come screeching to a halt. 

But don't be duped ...
Just because many small-cap stocks have seen a huge increase in the last few months doesn't mean you should avoid all of them.

First, no one accurately called the market's bottom in March, so it's dubious whether anyone now has the ability to call a top just a few months later.

Second, the Russell 2000's sharp rise has largely been driven by the speculative bidding-up of penny stocks (stocks with share prices below $5). Many companies whose share prices were above $5 per share in March have not shared in the astronomically high returns -- including companies whose fundamentals have actually improved year to date.

This trend isn't unique to small caps. In fact, S&P 500 stocks whose prices fell below $5 during this bear market -- including Ford (NYSE: F  ) , Genworth Financial (NYSE: GNW  ) , and Fifth Third Bancorp (Nasdaq: FITB  ) -- have been some of the highest gainers in that index.

But this still raises the question: Why have penny stocks risen quicker than non-penny stocks?

Pain, baby, pain
Behavioral psychologists refer to the "pain of paying" -- the mental barrier we face when parting with our cash. The higher the cost, the higher the barrier.

For investors focusing on share price (instead of, say, underlying company quality), it's less painful to toss an extra dime per share into purchasing a penny stock (even if this is twice what the stock was trading for the day before) than it is to toss in an extra $5 per share for a stock that was trading for more than $100 a share the day before.

Rational? Certainly not.

However, this speculative irrationality presents the savvy small-cap investor with a great opportunity.

How to cash in on small-cap movement
There are two ways you can profit from the rush to penny stocks:

1. Join the rush and gamble your hard-earned money by trying to guess which penny stock might rise next.
2. Invest in small-cap companies whose fundamentals have been improving, but which are still undervalued by the market.

As much as we'd all love to have a stock shoot up more than 5,000% in just a few months -- as penny-stock micro-cap Diedrich Coffee recently did -- at the end of the day, the first tactic is nothing but a risky crapshoot.

So though your inclination might be to go for the gusto to make up for losses, the second option is really the only way to set yourself up with a portfolio that will grow your wealth at above-average rates over long periods of time.

After all, the best small caps have the ability to consistently outperform -- which is why they have consistently been the top-performing stocks of the past four years.

Time to be smart
One stock I think you'd be smart to buy right now -- one that I have my eye on, and which the team at Motley Fool Hidden Gems recently bought -- is Brink's Home Security.

The company has a market cap of just $1.4 billion, and it boasts a clean balance sheet with $83 million in cash and zero debt. Best of all, it's currently trading for just eight times the team's calculation of steady-state cash flow.

The stock has risen significantly since the end of 2008 -- but the team still expects market-beating returns over the next two to three years, with very little risk. 

You can browse through their whole investment thesis, and examine their in-depth valuation of this company and many others, completely free with a trial membership to Hidden Gems. Click here for more information.

Already subscribe to Hidden Gems? Log in at the top of this page.

Adam J. Wiederman owns no shares of the companies mentioned above. The Motley Fool owns shares of Brink's Home Security, a Motley Fool Hidden Gems recommendation. The Fool's disclosure policy is anything but stupid.