When times are tough, most investors look to invest in the biggest, safest stocks they can find. But in the big market rally since October, the largest gains have come from the other end of the spectrum: small-cap companies that carry considerably more risk -- and better potential returns.
Later in this article, I'll point you toward several small-cap stocks that could provide explosive profits in the coming year. But first, let's take a look at why small caps could be poised to beat out their larger counterparts in 2012.
A tale of two markets
The tug-of-war between small caps and large caps consistently swings back and forth over time. During the recovery that followed the market bottom in March 2009, small-cap stocks performed extremely well, as many companies that the market had left for dead during the financial crisis not only survived but came back strongly. For instance, Crocs
But that outperformance largely disappeared in 2011, as large-cap stocks started to catch up. And in the big downturn for stocks in August and September, small caps fell a lot further than their larger rivals. As of Sept. 30, the small-cap Russell 2000 index fell more than twice as much as the large-cap Russell 1000 index.
Since October, though, small caps are back to their outperforming ways. According to figures compiled by The Wall Street Journal, the S&P SmallCap 600 has beaten the S&P 500 by about 8 percentage points as of Dec. 15. In yesterday's big rally, small caps again outpaced large caps by a considerable margin.
Why small caps?
The arguments favoring small caps are starting to add up. Small caps tend to do better in bull markets, and despite fears about Europe and other macroeconomic concerns, stocks have held up a lot better than they did in 2008 when they faced similar troubles.
But the WSJ notes that many small-cap stocks are richly valued. So if you want both exposure to smaller, faster-growing companies and a margin of safety, you'll need to dig down further rather than simply buying a small-cap index-tracking ETF.
As a starting point for further research, I ran a simple screen using the Motley Fool CAPS Screener to look for small caps with valuations at less than 10 times earnings but which merited top CAPS ratings. Here are five of the top prospects the screen delivered:
52-Week Price Change
Ship Finance International
Kulicke & Soffa
Source: Motley Fool CAPS.
Each of these stocks has promise, but they aren't risk-free. Both Cirrus Logic and OmniVision live and die by Apple products, with OmniVision taking a big hit when a look at the latest iPhone revealed that the company wasn't the sole provider of camera chips for the device. Ship Finance has struggled through a tough environment for tanker shipping companies, while dividend-rich Prospect Capital has threatened to make potentially dilutive secondary offerings of stock. And the semiconductor industry is extremely competitive, posing threats to Kulicke & Soffa.
Nevertheless, these stocks may be in the best position to rebound if the small-cap rally continues. Granted, some of them are extremely volatile and will likely fall sharply if the market slumps. But in the risk-reward spectrum, they have at least some resistance to downturns because of their relatively low valuations.
Buy the right stocks
If you've fled to large-cap stocks for their safety, I don't blame you. Sleeping well at night is worth a lot. But if you want the best returns in the next bull market, small caps are more likely to give you what you're looking for -- so start looking at these and other small-cap stocks today.
Our pick for the top stock for 2012 is a small cap in the Russell 2000, and we think it has good prospects even if the market doesn't do well next year. Learn all about it in this free special report from the Motley Fool today.
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Fool contributor Dan Caplinger thinks big but invests small. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Apple. Motley Fool newsletter services have recommended buying shares of and creating a bull call spread position on Apple. 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 covers you big and small.