Hot Small Caps in Cold Sectors

"Sorry to be the bearer of bad news, but you missed the run-up in stocks. That's right. The easy money's been made. Stocks are priced right now for a future economic reality that's highly unlikely: a happy one. Look at those aggregate market valuations, and take a peek at the run-up in many sectors. Stocks are priced for an end to unemployment, an upturn in home prices, and a return to consumer spending to rival the days of the great excess."

I hear that argument a lot these days. I read it in financial blogs. I hear it from TV's talking heads. Worst of all, I hear it coming from the right side of my brain, from the portion of the brain known to medicine as the "evil" cortex. I bet you hear it, too.

Did we blow it?
Have we missed out on the biggest rally in history? I don't think so. And I have a couple of good reasons. First of all, aggregate financial measures are meaningless as guides to individual investments. "The Market" is expensive? Based on what, an overall P/E? What good is the price-to-earnings (P/E) ratio on an entire group of 500 or more companies? Some companies have negative "earnings," some are experiencing abnormal one-time gains or losses for restructuring, and some are just normal.

Within the S&P 500, the spread is enormous. A company like Freeport-McMoRan Copper & Gold (NYSE:FCX), with a trailing-12-month loss of more than $12 billion, is lumped together with ExxonMobil (NYSE:XOM), which earned more than $31 billion over the same period. Clearly, judgments based on nonsense like this are worth what you pay to watch them on CNBC.

Taking it down a notch
Things get even crazier down in the place I do most of my stock hunting: Small-Cap Land. Because they tend to get crushed more in bear markets, small caps tend to lead out of recoveries. And small-cap returns over the past few months have been nothing short of phenomenal. So, you could be forgiven for asking, "Are the good times already over?"

But owing to Mr. Market's habit of looking at meaningless aggregates, there are pockets of opportunity that shouldn't be overlooked.

Look for winners among the losers
One way I find them is by checking sector returns broken out by market cap, because there can be a huge difference between how Mr. Market will treat companies in the same sector, depending on their size. Look at the difference in returns for telecoms, for instance:

Data from Capital IQ as of 8/29. Large-cap returns calculated off sector ETF. Small-cap returns from Index.

Wow. Small-cap telecoms have been brutalized over the past year and have yet to share in much of the recovery that's visited other stocks. Why is that the case? Probably because large-cap telecoms tend to have dominant franchises and steady cash flows -- enough money coming in to hold off the wolves even if the balance sheet isn't spotless. Small caps, during a time of financial upheaval, are more likely to be choked to death if their customer base dwindles, especially if they have debts to pay.

Still, if I'm going to go looking for small-cap bargains, one of my favorite strategies is to look for the stronger companies in the more hated sectors. Here's a look at how small-cap sector returns have played out over the past six and 12 months, to give us an idea of where we might begin looking. As you guessed, small-cap telecoms are at the top of the list of losers. Small-cap utilities fell less than many other sectors over the past year, but they still haven't done much over the past six months.

Data from Capital IQ as of 8/29. Large-cap returns calculated off sector ETF. Small-cap returns from Index.

Where's the opportunity?
At Motley Fool Hidden Gems, we favor small caps with good balance sheets. So, taking the bottom sectors for the past six months, and looking for only small-cap telecoms and utilities with small debt loads, we find a pretty select group indeed. Out of nearly 80 small-cap telecoms and utilities overall, only 16 meet my (admittedly arbitrary) hurdle of having net debt less than 25% of market cap. And it's no surprise to me that most of these have outperformed the small-cap telecom and utilities indices handily over the past six months.

Here are a few of the hot stocks in these cold small-cap sectors.

Foolish final thought
Of course, none of this means that any of these stocks is necessarily a home run from here. (If you disagree, let me know in the comments below.) For my purposes, these kinds of exercises are just a starting point. Before buying any of these, I'd need to know a lot more about the growth potential or sustainability of the business. I remember a lot of hype about Consolidated Water, for instance. The reverse-osmosis for the tropical islands story. But how big an opportunity is that really? Then, it'd be time for more digging into the finances. How's interest coverage? What would it look like if the top line stayed depressed 20% for a couple of more years?

Despite the work that remains after exercises like these, with thousands of small-cap companies to pick from out there, any system that helps pinpoint better performers in forgotten corners of the market will, I think, give us a head start on research.

In fact, one of the companies I dug up through this process happens to already be a Motley Fool Hidden Gems portfolio candidate, one that's next up on our list of real-money purchases. (For that reason, I can't spill it here.) But if you'd like to take a look, a risk-free trial to Hidden Gems is on me.