A Gentleman's Bet

With the Dow and S&P putting in fresh new 15-month highs yesterday, even the staunchest of bears are beginning to wonder: are we wrong? Small-cap sleuth James Boric is willing to place a wager on it…

I’m not usually a betting man, but today I’m going to make an exception. I’ve found a group of stocks that will likely outperform every major index over the next 12 months – by at least 15%. The reason I’m so sure: it’s happened time and time again dating back to the early 1920s. And it’s happening now.

I’ll tell you about my winning stock idea in a second. But first I want to remind you of an article I wrote almost one year ago today for The Daily Reckoning.

On Sept. 24 of last year, I told you to prepare for a recovery. I wasn’t so bold as to say when. But I knew the market would recover, soon. More importantly, I gave you a plan of attack to make back ALL the money you lost from 2000 to 2002 – if you had stuck it out in the stock market while it crashed.

At the time, it seemed like the financial world was going to hell in a hand-basket. The Dow Jones was down 35% from its all-time high in Jan. 2000. The S&P 500 was down 46% from its high in March of 2000. And the Russell 2000, the ‘small-cap index,’ was taking a beating as well. It was down 41% from its high in March 2000. Panic was in the air.

Small-Cap Stocks: Small-Caps Lead the Way

Despite the doom and gloom, I suggested last September, based on historical precedent, it was time to invest in fundamentally sound small-cap stocks. Why? One simple reason: for the last 100 years, small-cap stocks have led the way once the market turned from bear to bull.

Let’s take a stroll down memory lane…

In the recovery years following the crash of 1929, small- cap stocks outpaced large-cap stocks by about 20% a year – for four years.

Following the crash of 1973, small-caps rose 349% from 1975 to 1980. Their large-cap counterparts managed only 59% gains.

And after the downturn in 1982, small-cap stocks jumped up almost 37% by 1983. Again, large-cap stocks lagged behind – gaining only 21%.

The statistics are irrefutable. When the market turns from bear to bull, small-cap stocks have historically been the best class of stock to own – PERIOD.

Always have been? Perhaps, they always will be. Take this most recent rally for example. On March 11, 2003, the Dow was at its lowest point since October 2002 (just after the Sept. 11 terrorist attacks). It was trading at 7,524. Since then, it has rallied up to 9,523 – a gain of 27%.

Small-Cap Stocks: The Russell 2000

Not too shabby. But the Russell 2000’s turnaround has been far more impressive.

The Russell 2000 is a small-cap index. It hit a low of 345 on March 12. Today, it trades at 507 – up 47%. Just like in the 1940s, small-cap stocks are outpacing the blue chips by about 20%. In the last six months, had you invested in select small caps with sound fundamentals, you could have made back everything you lost in the 2000 fallout – just like I predicted.

So why don’t more investors forget about the slower-moving large-cap stocks and dump their money in the small-cap market?

Risk.

Most investors consider buying small-cap stocks ‘gambling,’ ‘speculation’ or very ‘high-risk.’ They are right to a degree – albeit a very small one.

In the late 1990s, Sherman Hanna, a professor at Ohio State University, and Peng Chen, an associate at Ibbotson Associates in Chicago, did a study on small-cap stocks versus large-cap stocks. They wanted to show how they stacked up against each other in the short, medium and long term.

Small-Cap Stocks: In for the Long Term

Here’s what they found…

Using data from 1926 to 1996, Hanna and Chen found that small-cap stocks are riskier if you hold for shorter periods of time. For instance, if you picked the absolute worst five-year holding period between 1926 and 1996 to invest in a basket of small-cap stocks, a $1 investment in that basket would have been worth 26 cents at the end of the five years. Scary.

But that’s the worst-case scenario – the number doom and gloomers will use to convince you to head to the hills and never look back. It’s not normal. So let’s look at what is.

In an average year, small-cap stocks outperform large-cap stocks 56% of the time. Bet you didn’t know that! And the longer you hold small-cap stocks, the more impressive the numbers get.

If you hold for 10 years, small-cap stocks will beat their large-cap counterparts 66% of the time. (Also, the 10-year mark is where the risk associated with holding small-cap stocks equals that of the large-caps. In other words, after 10 years, it’s actually riskier to hold large-cap stocks!)

And if you hold for longer than 10 years, forget about it. There’s no comparison between small-and large-cap stocks. During any 15-year holding period, small-cap stocks will beat out large-caps 78% of the time. Over 20 years, they win out 94%. And over 35 years, small-cap stocks have always beaten out the blue chips. Always.

Small-Cap Stocks: Fundamentally Sound

Let there be no doubt – if you are looking for a long-term investment strategy, you would be foolish not to consider small-cap stocks. But the question everyone wants an answer to is: How can I make money now? I don’t want to wait 20 years.

I’ll tell you the same thing now I told you last September. The secret is to look for fundamentally sound small-cap stocks.

Right now, there are 8,880 active companies (large and small) trading on the major U.S. exchanges. Of those, only 101 are fundamentally sound, growing enterprises. How many do you think are large blue chips?

Go ahead, guess.

Twenty-five? Fifty? Seventy-five? Nope. Try 14!

There are only 14 large-cap stocks that trade for 25 times earnings or less, 1.5 times sales or less, 1.5 times book value or less AND are growing th