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.

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:

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.