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 Cell Therapeutics (Nasdaq: CTIC  ) , Human Genome Sciences (Nasdaq: HGSI  ) , American Capital (Nasdaq: ACAS  ) , Patriot Coal (NYSE: PCX  ) -- all of which are up more than 500% since last year's market low." 

That's what you might be hearing, now that the small-cap Russell 2000 Index is outpacing the S&P 500 by more than 23 percentage points. Even The Wall Street Journal predicts that the small-cap rally is set to come to a screeching halt. 

But don't be duped ...
Just because many small-cap stocks have experienced a huge increase in the past months doesn't mean you should avoid all of them (though you should be careful of the risky stocks I just mentioned).

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

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 exceeded $5 in March have not shared in the astronomically high returns -- including companies whose fundamentals have actually improved.

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  ) , E*TRADE Financial (Nasdaq: ETFC  ) , and Qwest Communications (NYSE: Q  ) -- have been some of the highest gainers in that index, with each up more than 60% since the bottom.

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

Pain, baby, pain
For one thing, many of these companies faced the possibility of bankruptcy in the credit crisis, and now that that's less of a concern, their share prices reflect the fact that they probably won't be zero anytime soon.

There's also what behavioral psychologists refer to as 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 that dime represents 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 wager your hard-earned money by guessing 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 nearly 7,300% 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 several years.

Time to be smart
One company 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 purchased shares of -- is American Reprographics.

American Reprographics has a market cap of just $350 million.

The stock has done well over the past three months -- but the team still expects market-beating returns from this tiny company. 

You can browse through the team's whole investment thesis, and examine in-depth valuations of many small-cap companies, completely free with a trial membership to Hidden Gems. Click here for more information.

Already a member of Hidden Gems? Log in at the top of this page.

This article was originally published Aug. 24, 2009. It has been updated.

Adam J. Wiederman doesn't own shares of the companies mentioned above. Ford is a Motley Fool Stock Advisor recommendation. American Reprographics is a Hidden Gems selection. The Fool owns shares of American Reprographics. The Fool's disclosure policy is anything but stupid.

Read/Post Comments (6) | Recommend This Article (50)

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 March 09, 2010, at 3:20 PM, jyauser wrote:

    Man Adam somebody needs to stitch up your dirty mouth. You've lost so much credibility. You've been wrong about so many stocks out there. People lost money because of you.

  • Report this Comment On March 09, 2010, at 4:18 PM, ayoung1230 wrote:

    You would be a biggest fool not to invest in Ford and Citigroup for the next 2 to 5 year!

  • Report this Comment On March 09, 2010, at 6:02 PM, ayoung1230 wrote:

    Ford will be #1 automaker in the world. Cheers to the good work and wisdom to bring clean diesel to trucks and heavy vehicles. Want to see Ford to sell clean electric, hybrid gas & diesel cars and trucks to save more fuel. Let's be less and less dependent on foreign oil.

    Ford is #1 with $42B Cap and TM is out of favor with $132B Cap and $billion class action lawsuits. Dear Fools, do we NOW get the picture or not?

    Citigroup is the least expensive major banks in US and the world. Thanks to Mr. Pandit who has the Asian style of wisdom, intelligence and gracefulness to navigate Citigroup back to an American darling very soon. We will be the biggest Motley Fools not to invest in "F" and "C" at this point.

  • Report this Comment On March 09, 2010, at 7:36 PM, ayoung1230 wrote:

    Dear Ford,

    Listen very carefully to a Motley Fool’s call! Please quickly buy Hummer division as cheap as possible to build the best 4cyl electric clean diesel hybrid baby Hummers with different fun versions, the size of Jeep Cherokee, plenty of power, torque, fuel economy and 60% of the price of the new BMW X1d

    We are the American icons while they are not. Let’s shine all over the world and be better blockbuster than the original VW Beetles.

  • Report this Comment On March 09, 2010, at 10:36 PM, choconstruction wrote:

    I accidentally hit the Recommend Button on this article. Please subtract 1 from that count. Hahaha. I actually dont recommend this article to anyone as this is only a mere attempt to pump Amer Repographics. Sorry.

  • Report this Comment On March 10, 2010, at 1:59 AM, ayoung1230 wrote:

    Correction: I meant with the size of Jeep Wrangler not Jeep Cherochee. May be Cheridrochee sizes for 6cyl electric diesel hybrid for higher end grown up Hummers.

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