Your Best Bet for a Recovery

Throughout the bear market, big, well-known companies have taken huge falls -- and have gotten quite a bit of attention in the process. In the meantime, though, small-cap stocks stayed under the radar and actually held up fairly well early in the bear market.

But more recently, small caps have succumbed to the gravity of the falling market. And the unprecedented volatility we've seen among even large companies has caused ripples that have had a huge impact on how those who follow small caps look at these investments.

Blue-chip small caps?
This month's issue of The Motley Fool's Rule Your Retirement newsletter takes a closer look at small-cap stocks and the role they play in investor portfolios during a recession. Small companies have a reputation for being riskier and more volatile than their larger counterparts, but historically, they've performed better than large caps over the long haul.

But an interesting dynamic that we've seen pretty frequently in this severe bear market has been the devolving of former mid-cap and even large-cap stocks into small caps. With the overall market down close to 50% in the past 18 months, lots of companies have seen their market caps shrink significantly.

For instance, if you define small caps as companies with market capitalizations of $2 billion or less, take a look at some formerly much bigger stocks that now qualify:

Source: Yahoo! Finance as of April 8.

Yes, there's even a small-cap stock in the Dow Industrials -- at least by the $2 billion definition.

What this bear market has done is to force small-cap investors to look beyond up-and-coming young companies and deal with an incursion of much different stocks: mature, struggling businesses that find themselves in danger of losing everything. How does that change the prospects for investors in small caps?

Rebounds from all quarters
As Foolish retirement expert Robert Brokamp explains, a recovery doesn't just help new, young companies that have taken hits. Even well-established companies that fall back into small-cap territory can see big jumps when the market turns. In some cases, those former giants bounce back with a vengeance.

For instance, the newsletter points out the experience of one stock that lost over 98% of its value, seeing its former market cap of over $10 billion drop to just a few hundred million dollars. Yet just since last month's market low, the stock has more than doubled in price, far outpacing the overall market.

Historically, though, small caps of all sorts have performed well after recessions. Robert notes that following nearly every recession, small stocks have done better than their large-cap rivals.

Pick the right stocks
The best small-cap stocks -- regardless of their past history -- share some desirable traits. As investors, you should look for the following:

• Founders making big bets. Small-company founders who believe in what they're doing won't sell out in their IPO -- they'll hold on for the big money, and bring their shareholders with them.
• Great financials. You should understand these companies' financial statements, and they should look attractive, without huge debt or other obligations. Make sure that they have the capital to make it out of the starting gate -- or get back into the big time.
• Room to grow. Whether you're looking at a brand-new company or a down-and-out stock looking to bounce back, you want the business you invest in to have real growth prospects.

At times like these, sticking with well-known large-cap stocks is tempting. But if you do that, you risk missing out on some of the best returns you'll ever earn -- returns that could make a big difference in your retirement. That's a mistake you don't want to make, especially if you want to make up for big losses over the past year.

For more on the right investments for your retirement, read about:

• The real reason you should be buying stocks.
• Should you cash out now?
• Or are happy days here to stay?