These Small-Cap Winners Are Still Cheap

Many investors have bemoaned the so-called lost decade for stocks. But many investors who strayed from the most obvious investments have actually done quite well over the past 10 years, and although they are starting to have to be more selective with their stock picks, there are still plenty of good opportunities in parts of the markets that many investors never really venture into.

A tale of two markets
By now, you know all too well the sad saga of the stock market since 2000. Despite the promise that stocks always go up, major market indexes like the S&P 500 have actually fallen since the turn of the millennium. That has led many investors to give up on stocks entirely, arguing that it must be a rigged game.

If you invested in small-cap stocks, however, you've seen a much different picture. As the New York Times pointed out over the weekend, investors in S&P's index of small-cap stocks, the S&P Smallcap 600, have earned annual returns of 8% on average during the past decade -- returns that while not spectacular, beat the pants off the large-cap S&P 500's average returns of less than 1%.

What's behind that outperformance? To understand one important factor, think back to the stock market rally in the late 1990s. Technology stocks exploded in value, with a host of formerly unknown names gaining large-cap status despite relatively short histories and joining the S&P 500. Then, just in time for the large-cap index to rebalance itself toward huge exposure to tech stocks, the bottom fell out of the market, sending those large caps for a loop.

Of course, small-cap stocks didn't move straight up while large caps were falling. But during the bear market from 2000 to 2002, the S&P Smallcap 600 dropped less than 1% -- and it actually rose dramatically during the first part of the tech bust before finally giving up ground toward the latter part of 2002.

Dealing with an expensive market
The good news with small caps has been their tenacity in the face of challenging markets. But that poses a problem for investors who are just now looking to get into small-cap stocks. Because of their resiliency, many small caps don't carry bargain prices anymore. With the small-cap index up about 23% so far this year -- a much bigger jump than the S&P 500's 11% gain -- valuations on some small-cap stocks have risen dramatically.

But that doesn't mean every small-cap stock is overvalued. To see if there are any bargains left out there, I screened for small-cap stocks with a substantial following on Motley Fool CAPS. The screen picked stocks with earnings multiples of 12 or less despite having risen at least 50% in the past 12 months. These were the top-returning stocks that the screen produced:

Company

12-Month Return

Current P/E

SunOpta (Nasdaq: STKL  ) 131.7% 8.9
Ariad Pharmaceuticals (Nasdaq: ARIA  ) 118.1% 5.6
Puda Coal (AMEX: PUDA  ) 98.4% 11.3
Domino's Pizza (NYSE: DPZ  ) 95.9% 10.4
Sunrise Senior Living (NYSE: SRZ  ) 73.5% 4.9
American Axle (NYSE: AXL  ) 68.3% 5.9

Source: Motley Fool CAPS.

Of course, these stocks aren't automatically buy candidates. Canadian natural food maker SunOpta has gone on a big acquisition spree lately, but unless those new pieces immediately add to earnings, the stock's P/E could rise in the near future. Biotech Ariad is in a similar situation, having reaped a big one-time gain that pushed its P/E down, while Sunrise Senior Living resorted to selling assets to competitors, including Brookdale Senior Living (NYSE: BKD  ) , in order to raise cash and pay down debt. And although Chinese coal producer Puda is riding high on China's commodity boom, it's vulnerable to any slowdown there. That might lead you to conclude that those stocks aren't particularly cheap.

But some of these stocks have better prospects. Domino's and American Axle aren't expected to grow earnings substantially next year, but their current earnings levels aren't one-time aberrations. Even after huge runs, there's reason to believe that the top isn't necessarily hit for those two stocks.

Think small
Small caps can be hard to figure out, as they don't get anywhere near as much attention as their bigger counterparts. But that's one reason why you can find great stocks in the small-cap space. By seeking great stocks where others don't bother looking, your odds of finding a winner are much better.

Small caps are just one element of a smart retirement portfolio. Fill in your other gaps by clicking here to read the Fool's new special report, The 7 Secrets to Salvage Your Retirement Today.

Fool contributor Dan Caplinger loves to think small and win. He doesn't own shares of the companies mentioned in this article. The Fool owns shares of Domino's Pizza. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy loves cheap pizza and cheap stocks, not necessarily in that order.


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