The Best Stocks for the Next 4 Years

I'm not bold enough to call a bear-market bottom, but I do believe we're close.

For starters, market data reveals that by the time stocks enter bear-market territory (which happened back on July 9), roughly three-quarters of the drop is history. For another thing, it's difficult to find even a smidgen of positive market news among the panic.

Sure, things are bad. Thanks to the past year, even long-term investors in giants such as General Motors (NYSE:GM), Advanced Micro Devices (NYSE:AMD), XL Capital (NYSE:XL), and even Level 3 Communications (NASDAQ:LVLT) have netted annualized losses of more than 15% over the past 10 years.

But many analysts are predicting even greater index drops. Jim Cramer, on a recent Today Show appearance, told investors that stocks will still fall, on top of the precipitous drops the markets have already seen!

It's safe to say negativity abounds
The late Sir John Templeton called times like this "points of maximum pessimism." He also taught that times of maximum pessimism are the best time to buy -- and he practiced what he preached.

When the Second World War began and stocks started to fall, he borrowed $10,000 and invested it in 104 companies whose shares were trading for less than $1 -- including 34 that were in bankruptcy. Four years later, he sold his positions for $40,000 and booked a 300% gain on stocks the market thought were doomed.

With his example in mind, I believe the current pessimistic consensus signals a buying opportunity.

Stocks to profit from pessimism
We should be buying stocks that, like Templeton's initial bet on pessimism, could become double- or triple-baggers in the four or so years coming out of this bear market.

We know the top stocks since the last recession began were mostly small caps -- albeit with a few large-cap rock stars like Apple and PotashCorp mixed in. Among other things, small companies can more quickly and efficiently cut costs and streamline operations than can larger companies with employees and resources scattered throughout the country and the world.

But what kinds of companies outperformed since the end of that bear market? I ran a screen to see what kinds of companies were double-, triple-, or even-better-baggers as the recession receded. And sure enough, the best-performing companies over the following four years were all small caps:

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

This list merely shows the top 10, but it's also true that small caps as a whole outperformed their larger brethren coming out of the last bear market -- and this phenomenon wasn't unique to that situation. According to T. Rowe Price research, small-cap stocks led the market out of the past 10 recessions, posting an average 28% gain, versus the 19% gain for large caps in the year following the market's recovery.

Given this data, I also ran a screen to see what small caps are dirt cheap right now -- and poised to outperform as the market recovers. I looked for companies down more than 70% over the past year, and trading with price-to-earnings ratios below both that of the S&P 500 and their five-year average -- qualities I believe could make for Templeton-sized gains over the next four years.

Here are three companies from that screen. These aren't formal recommendations, but they're a good place to begin some further research.

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

All in the family
So if, like me, you're looking for the best stocks to carry your portfolio out of this bear market and into wealthy pastures in four years' time, you need to look for small, underfollowed companies like those above -- and like those we search for as additions to our Motley Fool Hidden Gems portfolio.

Hidden Gems is outperforming the market by more than six  percentage points -- and every month, advisors Andy Cross and Seth Jayson add two new recommendations, as well as their best ideas for new money now. If you'd like more insight into the market's best small-cap stocks right now -- including which ones we recommend -- try the service out with a 30-day free trial. Click here to get started -- there's no obligation to subscribe.

This article was originally published Sept. 5, 2008. It has been updated.

Adam J. Wiederman owns none of the stocks mentioned above. Tata Motors is a Motley Fool Global Gains recommendation. Apple is a Stock Advisor recommendation. The Motley Fool's bold disclosure policy is here.