Now's the Time to Invest in These Stocks

Individual investors: The coast is clear. It's time to invest in small caps again.

Yes, small caps have indeed rebounded along with the rest of the market since the March lows, and you still need to be selective, but as a result of three major changes in the market, individual investors like you and me once again have a tremendous opportunity to find great values in the small-cap market.

Why this matters to you
Small-cap stocks, bought prudently and patiently, can be an individual investor's best friend.

Why? For one, institutional investors (mutual funds, pensions, endowments, etc.), which manage billions in assets, have a difficult time buying meaningful stakes in small companies without consequently buying controlling stakes in the company. Remember, large fund managers are more interested in making money from their investments than running dozens of tiny businesses, so they are forced to invest in larger companies that can absorb their sizeable investment amounts.

Warren Buffett has lamented that he could earn 50% annualized returns if he had less than $1 million to invest, but with the massive Berkshire Hathaway portfolio, he's forced to focus on the Coca-Colas (NYSE: KO  ) of the world. In fact, not even 0.5% of the Berkshire portfolio is dedicated to small- and micro-cap companies. They're simply too small for him to buy.

Second, precisely because the big fish reside in the large-cap ocean, that's where most of the analysts reside, too, and that presents an information gap that the astute individual investor can exploit. As former Wall Street analyst Stephen T. McClellan noted in his book Full of Bull, "Most analysts at major firms get attention and make their reputations by emphasizing big cap recommendations. Small stocks present the individual investor with a better prospect of undiscovered value and the potential to achieve greater prominence in the future as their market caps expand."

Individual investors stand little chance of finding multibaggers among these titanic stocks with so much analyst coverage:

Company

Number  of Analysts Covering

Verizon (NYSE: VZ  )

24

Apple (Nasdaq: AAPL  )

34

Intel (Nasdaq: INTC  )

38

Google (Nasdaq: GOOG  )

29

Chevron (NYSE: CVX  )

14

Alcoa (NYSE: AA  )

15

Data provided by Yahoo! Finance, as of Dec. 1.

No doubt, these are all solid companies, and the individual investor can profit from them as well, but it's unlikely that we'll find an information edge on the Wall Street wingtip crowd on a stock like Intel.

And that's OK. We just need to play to our strengths as individual investors, and thanks to the three changes in the market, now's the time to take advantage of our opportunity.

Carpe diem
So what are the three major changes?

1. The disappearance of hedge funds. During the Roaring Mid-'00s, upstart hedge funds, which were battling one another tooth and nail for outperformance to attract more assets, flocked to the small-cap market in hope of profiting from the inherent market inefficiencies. In fact, at the height of the market, one survey found that hedge fund holdings of some small-cap stocks grew by 40% year over year. Since the credit crisis began in 2008, however, about 2,100 hedge funds have gone under, and they've taken their interest in small stocks with them.

2. The emergence of "high-frequency" traders. As the hedge funds fell apart in 2008, high-frequency traders picked up the slack. Armed with supercomputers and complex algorithms, the high-frequency traders hunt for the slightest "signals" or inefficiencies in the market and process trades in microseconds. Given the relative illiquidity of the small-cap markets, these high-frequency programs need to focus on larger, more frequently traded companies.

3. Shrinking Wall Street research budgets. According to Capital Institutional Services, commissions at investment banks (which fund research) are expected to drop 20% to 40% year over year. This had led to reduced research budgets, a decline in analyst staffing levels, and coverage of fewer stocks.

Wall Street's reduced coverage of small caps is overall good news for us as individual investors, but it will force us to be more patient with our investments and hold them longer,  because it may take time for the big money to catch on to a big winner.

3 ideas to get you started
Don't worry. I'm not going to leave you without providing some specific stock ideas to help you profit from these three changes. They are:

1. Almost Family: A $330 million company that provides visiting-nurse and personal-care services. In 2008, 92.2% of its revenues came from Medicare, Medicaid, or another government program, so it's already well-versed in a government-payer system. Analysts covering: Seven.

2. FormFactor: An $860 million technology company that develops systems to test semiconductor chips and wafers and generates just 30% of its revenue in North America. The company's customers are set to introduce new designs this year, which could boost sales. Analysts covering: Five.

3. Sun Hydraulics: A $425 million maker of screw-in hydraulic manifolds and valves for hydraulic systems used in end markets like construction, agriculture, and mining equipment. As a cyclical company, it has naturally taken some lumps in this recession, but it's well-managed and carries a solid balance sheet and significant insider ownership, so it's poised to profit when the economy recovers. Wait for a pullback from current prices and be ready to pull the trigger if it gets back to the low $20s. Analysts covering: Three.

Foolish bottom line
Small-cap stocks present individual investors with an opportunity to invest in great companies before the rest of the market catches on. Today, with institutional investors increasingly focused on large-cap behemoths, now's the time to invest in small caps.

If you'd like more small-cap ideas, take a 30-day free trial of our Motley Fool Hidden Gems service. Click here to get started. There's no obligation to subscribe.

Fool analyst Todd Wenning wishes everyone a happy holiday season. He does not own shares of any company mentioned. Google is a Motley Fool Rule Breakers selection. Apple and Berkshire Hathaway are Stock Advisor recommendations. Intel, Berkshire Hathaway, and Coca-Cola are Inside Value recommendations. Sun Hydraulics, Form Factor, and Almost Family are Hidden Gems picks. Coca-Cola is an Income Investor recommendation. Motley Fool Options recommends a buy call on Intel. The Fool owns shares of Berkshire Hathaway and FormFactor, and has a disclosure policy.


Read/Post Comments (29) | Recommend This Article (181)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 03, 2009, at 5:25 PM, leespitler wrote:

    I did not join this service to constantly be solicited with offers for other products!

  • Report this Comment On December 03, 2009, at 6:50 PM, horsemanure wrote:

    Ditto

  • Report this Comment On December 03, 2009, at 6:52 PM, jameshusby wrote:

    I second leespitler. Quite trying to separate me from my money every two seconds.

  • Report this Comment On December 03, 2009, at 7:09 PM, TMFBreakerRob wrote:

    You can "opt out" of getting Fool emails by going to "My Fool", then "My Settings" and making the appropriate choices. Not so bad....

    I've chosen to get the emails because sometimes there are good ideas I've followed up on. In the same way, I've got 200+ boards saved as "Favorites" so I can search for those good ideas. Takes time, but its worth it to me.

    Good luck!

  • Report this Comment On December 03, 2009, at 7:43 PM, OPTIONNUT wrote:

    OK...So you provide us with three companies to invest our money. Why not provide us with the symbols for these stocks and what these analysts are saying?

  • Report this Comment On December 03, 2009, at 8:57 PM, Chinastocks55 wrote:

    Is this guy kidding?

    Buy NEP.......a monster China oil play.

    Or LIPH.OB......a tremendous China gasoline and oil play.

    Take a look at this link:

    http://www.thestreet.com/_yahoo/story/10636729/1/china-micro...

  • Report this Comment On December 03, 2009, at 8:57 PM, Chinastocks55 wrote:
  • Report this Comment On December 03, 2009, at 10:17 PM, procd wrote:

    I just checked the short positions on all three -- as a percent of float, the numbers are ....

    AFAM 15%

    FORM 9.9%

    SNHY 11%

    So these clowns have likely covered and they are trying to drive up the PPS via a big pump.

    What is the word for people like this?

  • Report this Comment On December 04, 2009, at 8:45 AM, wisconron wrote:

    procd, please explain your meaning of what is happening with short covering, the % short and the effect. Have idea just would like clarification, I never take anything for granted with money.

  • Report this Comment On December 04, 2009, at 9:25 AM, ziq wrote:

    "OK Fools, Why not provide us the symbols for these three new companies?"

    Maybe because you should be doing your own research, which should include, minimally, the half second it takes you to do a symbol look-up.

  • Report this Comment On December 04, 2009, at 9:58 AM, malcarada wrote:

    I still think the symbols for the stock should have been provided really.

    If it takes me half second to look it up then it also takes half a second to look it up for the author too.

  • Report this Comment On December 04, 2009, at 12:56 PM, johnis9 wrote:

    Thanks for the three stocks, these three are awesome stocks which are very dependable in the coming year. But i would also recommend a Undervalued stock SAY this is presently so cheap because of misdeeds of old CEO but it is taken over and looks ready to run next year.

    --www.bit.ly/lookat9

  • Report this Comment On December 05, 2009, at 6:34 PM, mikecart1 wrote:

    Another "beat around the bush" article by TMF. What a great site we have here...

  • Report this Comment On December 07, 2009, at 7:10 PM, Netteligent09 wrote:

    As a customer, I never sign up with Verizon again. As investors, using your money somewhere else. Verizon, Earthlink, Charter Comm. and AOL the worst telecom company with bad service.

  • Report this Comment On December 10, 2009, at 3:00 PM, Shepp67 wrote:

    Its not time to pickup AFAM now, imho of course. South of 30.00 is when I'd consider getting back in.

  • Report this Comment On December 11, 2009, at 7:28 AM, RCS2rocks wrote:

    I would like to wish Todd Wenning as well as everyone a Merry Christmas!

  • Report this Comment On December 11, 2009, at 7:36 AM, RCS2rocks wrote:

    I would like to wish Todd Wenning and everyone a Merry Christmas!

  • Report this Comment On December 11, 2009, at 2:13 PM, camainc1 wrote:

    TheStreet rates FORM a SELL. "The company's weaknesses can be seen in multiple areas, such as its feeble growth in its earnings per share, deteriorating net income, disappointing return on equity and weak operating cash flow."

    Others rate them as REDUCE, HOLD, AVOID, or SELL.

    What does this author know about this company that no one else does?

  • Report this Comment On December 11, 2009, at 2:40 PM, birder1500 wrote:

    Well, if FORM is a Sell, it is probably a good time to buy.

  • Report this Comment On December 11, 2009, at 4:21 PM, Aneirin wrote:

    I found out about AFAM a while back (and recommended it in CAPS). Since then it's up quite a bit, and that was before TMF wrote about it a lot, so I doubt it's something the Fool is just pumping up. Less of a good buy now but still decent.

  • Report this Comment On December 11, 2009, at 6:12 PM, bullardrr wrote:

    SNHY at $20? You must be kidding. A buy at a P/E over 100? I second wisconsinron's puzzlement on procd's short analysis. What contract date? Total value of contracts for total value of float? At what instant?

  • Report this Comment On December 12, 2009, at 11:08 AM, VegasMartin wrote:

    I agree. If you invested in Green Mountain Coffee Roaster (GMCR) or Panrra Bread (PNRA) back in 2000, you're sitting on a 2,000% gain. Both were $3 stock. Now trading at $60+.

    http://www.ShootTheBears.com

  • Report this Comment On December 12, 2009, at 11:13 AM, VegasMartin wrote:

    I would also say that I would want a portfolio with 50% large cap, %15 foreign, 15% small cap, and 10% gold. That seems to strike the right balance.

    http://www.ShootTheBears.com

  • Report this Comment On December 12, 2009, at 11:19 AM, drlam wrote:

    I think TMFBreakerRob is right, anything from MF is worth at least a quick read. And another thing- doesn't MF preach buy and hold, so these companies are worth checking out. Right?

  • Report this Comment On December 12, 2009, at 11:35 AM, drlam wrote:

    I agree with Nettelgent09 that Verizon is the worst company and I would rather send smoke signals than EVER use that company again. I'm a great shopper and the last thing I look for before I buy a stock is would I ever purchase from this company. So Verizon is definitely out of the question.

  • Report this Comment On December 12, 2009, at 12:11 PM, IIcx wrote:

    Interesting timing Todd but I agree with the premise -- its always a good time to buy the right company at the right price.

    But, It might make sense to wait and see if the Yen strengthens next week. If it doesn't, the USD rally is a head fake and commodities will rise as the dollar falls driving companies within certain sectors up or down based on their related need.

    If the Yen does rise next week, it looks like the USD has a life of its own again and stocks are likely to fall until they decouple from the value of the dollar which shouldn't take very long to occur.

    Yet, both of these could present a great small cap buying opportunity. The markets appear to be in a stealth rotation/correction that is unlikely to produce major sell-offs unless something geo-political occurs.

  • Report this Comment On December 14, 2009, at 9:02 AM, donw43 wrote:

    <quote>shepp67 - Its not time to pickup AFAM now. South of 30.00 is when I'd consider getting back in. </quote>

    That looks to me like it might be a long wait my friend! :)

  • Report this Comment On December 11, 2010, at 1:06 AM, tstalkin101 wrote:

    well..a year later...

    TMF picks on this board are 1 of three.. ugly at best

  • Report this Comment On May 21, 2011, at 10:30 AM, essachap wrote:

    What is the uproar on buying Iraq's dinars?

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