You'd Be Stupid to Buy These Stocks

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

That's what a lot of investors are saying now that the small-cap Russell 2000 Index is outpacing the S&P 500 by nearly 30 percentage points. Even The Wall Street Journal recently predicted 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 over the past year doesn't mean you should avoid all of them (though you should be careful of the risky stocks I'm about to share).

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 "junky" penny stocks (defined as stocks with share prices below $5).

Just take a look at some of these biggest small-cap winners and the frighteningly high leverage they still carry even after their significant gains. This high leverage is problematic because if these companies once again run into declining business (as happened during the recession), they could again run into difficulty meeting debt obligations. And this is a problem because these mind-boggling gains would then be quickly erased as the stocks plummet.

Company

Gains Off Market Bottom (3/9/2009)

Share Price on 3/9/2009

Long-Term Debt/Equity

Sirius XM Radio (Nasdaq: SIRI  )

622.4%

$0.15

2,053.2%

Conexant Systems (Nasdaq: CNXT  )

737.1%

$0.35

2,678.1%

General Growth Properties (NYSE: GGP  )

3,786.8%

$0.38

2,840.9%

Data from Capital IQ, a division of Standard & Poor's.

Sure, those gains are nice, but both now and at the market bottom, these three highly leveraged stocks were extremely risky bets that most investors would be wise to avoid.

And this trend of "junky" stocks rising wasn't unique to small caps. In fact, here are three highly leveraged S&P 500 companies that were -- and still are -- equally risky, in my opinion:

Company

Gains Off Market Bottom (3/9/2009)

Share Price on 3/9/2009

Long-Term Debt/Equity

Goodyear Tire & Rubber (NYSE: GT  )

229%

$3.90

594.1%

Advanced Micro Devices (NYSE: AMD  )

320.1%

$2.14

326.8%

Tenet Healthcare (NYSE: THC  )

523.3%

$0.90

577.9%

Data from Capital IQ.

Of course 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 that 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 (NYSE: ARP  ) .

American Reprographics has a market cap of just $460 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. 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 (14) | Recommend This Article (23)

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 May 11, 2010, at 7:11 PM, brightsideLP wrote:

    GGP doesnt have that debt to equity ratio. Not even close. How do you get away with writing this stuff ?

  • Report this Comment On May 11, 2010, at 7:22 PM, goalie37 wrote:

    I wish you'd given a better pitch as to why ARP is worth taking a look at. All you did was give us a ticker symbol. Motley Fool usually does much better than that.

  • Report this Comment On May 11, 2010, at 7:46 PM, justinbauer1 wrote:

    This is garbage... Is there no fact checking on this site?

  • Report this Comment On May 11, 2010, at 8:18 PM, wolfwuf wrote:

    What high school term paper did this come out of?

  • Report this Comment On May 11, 2010, at 9:02 PM, PokerRon wrote:

    Oh, so it's back to Sirius XM bashing now is it? You will be proven wrong on this stock, just as you got it completely wrong on Middleby.

  • Report this Comment On May 11, 2010, at 10:17 PM, osunickerbocker wrote:

    Did this article just call a 4.08B Cap SIRI a small cap? No wonder we had a recession.

  • Report this Comment On May 11, 2010, at 10:31 PM, Fredlee009 wrote:

    Sirius XM is not a small cap stock. Market cap of almost 5 billion dollars.

  • Report this Comment On May 11, 2010, at 11:58 PM, ItAintCool wrote:

    Adam,

    Do you post in the comment section under the name SIRIDouche...um I mean SIRIDoom?

    You sure sound like him. No facts, lots of figures and all negative on SIRI.

  • Report this Comment On May 12, 2010, at 12:17 AM, y2khatib wrote:

    The title of this stupid article should be " You'd Be Stupid NOT to Buy These Stocks". The author failed to state facts about GGP; this is an owner of 204 AAA Malls in the U.S.; will exit BK in September this year and and you'll need to watch for the stock price as the mutual fund companies and institutional investors will skyrockety the price of this stock while the BIG DOGS are holding on!

  • Report this Comment On May 12, 2010, at 12:59 AM, cnight80 wrote:

    Are you kidding me??? This pathetic excuse for a writer thinks he's a genius for coming up with a catchy title and then writing a total hack job of an article. Wait til howard stern signs and the stock goes up to $1.50..... hopefully that will be a clue to motley fool that this high school drop out should stick to commenting on something simple like fantasy sports, not the stock market. I'm done w/ the MF site after this, just total BS.

  • Report this Comment On May 12, 2010, at 12:26 PM, onlitrade wrote:

    What type of article do you expect from a "Fool?" Since early 2009 buyers of these stocks have been laughing all the way to the bank. Most of these stocks are a good long term investment. Do your homework and see what these stocks were trading for in 1999. Most will reach their previous highs.

  • Report this Comment On May 12, 2010, at 12:49 PM, dogbot wrote:

    This article is very misleading about CNXT. First off they restructed most of their long term debt and I am sure the Debt to Equity is no longer accurate. Second this fails to take into consideration any sort of ability to pay (quick ratio, cash flow etc.) This stock has the potential to be a real Hidden Gem if there new products are halfway successful this stock is a steal at $3. Forward PE of less than 10 for a growth stock.... In summary I am proud to be stupid.

  • Report this Comment On May 19, 2010, at 12:44 PM, feudi wrote:

    The only company I know about is Tenet Healthcare, and only a fool would buy that stock. The only reasoned it hasn't filed for bankruptcy is because of the political connections on its Board. Jeb Bush covers Tenet for Wall Street while Bob Kerrey gives the company street cred with the SEIU. When is the SEC going to claw back that $111,000,000 that Jeffrey Barbakow swindled from Medicare in 2001-02???

  • Report this Comment On July 26, 2010, at 11:41 AM, Ibitit wrote:

    Matbe I'm wrong but I bought 1000 CNXT at around $2.00 a couple years ago and I still own it at $2.36 except that now I only have 100 shares. I seem to remember a one-for-ten reverse split at some point. I suspect this was not factored into the 2000+ gain shown in the above report. If I am right, please correct the figures in your article.

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