Just as the bear market in 2008 didn't spare many stocks from its wrath, the stock market's huge rally since March has pulled most stocks back up from the abyss. But one group of stocks has played its traditional role in leading the stock market toward an economic recovery. Now that those stocks have posted impressive gains, investors have to wonder: Do they have any room left to run, or should you steer clear until a long-overdue correction finally makes them more affordable again?
Big gains in small packages
In this month's new issue of the Fool's Rule Your Retirement newsletter, Foolish retirement investing expert Robert Brokamp revisits the world of small-cap stocks. Back in April, Robert looked at the historical data from past recessions, noting that in nearly every instance, small-cap stocks dramatically outperformed their large-cap counterparts in the recovery year following recessions. With an advantage of more than 20 percentage points, small-caps didn't just beat large-caps; they pummeled them.
Fast-forward six months, and you can see that Robert's prediction has borne itself out in the figures from the market rally. Large-cap stocks such as Apple (Nasdaq: AAPL ) and Google (Nasdaq: GOOG ) have performed extremely well; one S&P index fund is up 57% since the market hit bottom. But small-caps have done a lot better, beating the S&P by 33 percentage points since the March lows.
Flying too high?
Yet 90% returns aren't just unusual -- they're downright scary, especially if you've missed out on the rally by staying on the sidelines, and you're trying to figure out how to invest at these much-higher levels. With stocks such as Tenet Healthcare (NYSE: THC ) and Office Depot (NYSE: ODP ) trading at five and 10 times what they fetched back in March, the margin of safety on many small-cap stocks has pretty much disappeared.
Moreover, the small-cap investing world is starting to get crowded again, as performance-chasing mutual fund investors trade out of their large-cap holdings to snap up shares of hot small-cap funds. Contrarians might see that as a good reason to head for the door.
Where the good wild things are
But even after a big run-up in price, you don't have to give up on small-cap stocks entirely. While the easy money has already been made, small-cap investors can still find good stocks at reasonable prices. You may just need to look a little harder, or wait a little longer for the right opportunities.
For investors seeking a good all-purpose small-cap mutual fund, Robert has discovered what he considers a great pick for conservative investors. With stock picks such as Rofin-Sinar Technologies (Nasdaq: RSTI ) and Bio-Rad Laboratories, the fund is up significantly this year, despite having a large cash position, and it has averaged nearly 11% annually over the past 10 years.
On the other hand, if you're willing to take on more risk, another good place to look for great returns is the micro-cap space. Focusing on companies in the $100 million to $250 million market-cap range, micro-caps aren't for meek investors, but they can pack a punch when the time is right. One fund that Robert mentions combines tiny stocks such as Providence Service with more established small-caps like Buffalo Wild Wings (Nasdaq: BWLD ) and PetMed Express (Nasdaq: PETS ) , which have posted a reasonable return for the year.
Do small-caps belong in your portfolio?
In general, small-cap stocks are best for those willing to sacrifice safety for higher returns. So if lofty share prices have you already feeling the heat in your stock portfolio, you might want to wait for a pullback before you add small-caps to your overall investing strategy. But for long-term investors, small-caps can help you diversify your portfolio. And if the recovery truly is just getting started, the gains you've seen could just be the tip of the iceberg.
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