Two Compelling Small Caps for This Recession

by Lou Basenese

Over one million jobs vanished this year. Retail sales cratered for the eleventh consecutive month. Auto sales, and for that matter automakers, are headed for the junkyard. And there’s no sign of consumer confidence anywhere.

It’s not official yet. Apparently the committee of “esteemed” economists at the National Bureau of Economic Research (NBER) doesn’t get paid for timeliness. But the statistics don’t lie… we’re in a recession.

And that’s got me giddier than an Obama supporter scoring an inauguration ticket. That’s right. I’m actually glad the economic data stinks. Because when a recession is here, a small-cap rally isn’t far behind.

Accordingly, I’m loading up on small caps in my own portfolio. I suggest you do the same, instead of joining the lemmings piling into Treasuries. If you’re reluctant and afraid small caps are too risky, chew on this:

In the year following the six major bear markets of the last century, small cap stocks soared an average of 82%, according to Ibbotson Associates. If the prospect of an 82% gain doesn’t excite you in these trying markets, check your pulse. If it does, read on…

Any Old Small Cap Just Won’t Do

There’s no denying the strong historical trend, but it doesn’t mean ALL small caps will soar. Nothing in investing is ever that easy. In order to really benefit from the imminent rally, we need to isolate the most compelling and innovative small-cap stocks.

To that end, let me share a disciplined approach that’s always served me well. When it comes to small caps, I focus exclusively on companies with these three characteristics:

• A pioneer on the verge of creating new trends. Companies can create products to compete in existing markets… Or they can create products that are so revolutionary and timely that they launch their own markets and trends. The latter obviously positions the company, and in turn investors, to reap the most profits. If you need help qualifying this factor think Intuitive Surgical (ISRG), Google (GOOG), even VMware (VMW).
• Within three years of an initial public offering (or major index listing). Smaller and/or newer companies have more room to grow. Plus, Wall Street tends to overlook many of these firms. By focusing on these young and virgin opportunities, we can actually profit ahead of the Wall Street institutions and the trillions in capital they control.
• Increasing earnings by at least 30%. A market panic can only hold back fast growing stocks for so long. Eventually, share prices will follow earnings. By focusing on companies with the strongest growth profiles, we set ourselves up for the most dramatic gains. And yes, even in this market such companies do exist.

Other characteristics worth screening for include: recurring revenue streams, potential applications for products in parallel markets, new products in the pipeline, little or no analyst coverage and management ownership of 10% or more.

Granted, the process of actually finding such companies is tedious and time consuming. But as Abraham Lincoln quipped, “Things [profits] may come to those who wait, but only the things [profits] left by those who hustle.” In other words, all the hard work we put into identifying these small-cap stocks will be rewarded. But if we don’t grab the profits while we can, another investor will.

Short on Time? Buy These 2 Small Caps… And Call Me in a Year

I recognize not all of us can scour the markets each day in search of the most compelling opportunities. So let me make it easy for you. Here are two small-cap companies I’m convinced will be 50% higher (or more) a year from now. 

• Genoptix, Inc. (GXDX) The economic cycle doesn’t impact business for this provider of bone marrow and blood-based cancer tests one bit. Sadly, when it comes to diagnosing cancer, people can’t wait for better times. But the company’s focus on community-based oncologists also provides ample growth opportunities. Earnings increased 198% in the last nine months to $26 million. And yet, the company still only controls 4% of the market.
• American Public Education, Inc. (APEI) This West Virginia-based company provides online, post-secondary education to a very specific market - military personnel. Its niche focus is delivering impressive growth, with revenues and earnings up 56% and 72%, respectively, in the most recent quarter.

Whether you opt for these recommendations or seek out your own, it doesn’t matter. A recession is here, so a small-cap rally isn’t far behind. Before it’s too late, I recommend you position yourself accordingly.

Comments

[NotChuck:]

APEI: A focus on ongoing education is compelling to me in a market where knowledge is going to be even more important going forward. In addition, the military has seen higher enlistment recently due to better news on Iraq, boosting their target market in the future.

2008 Nov 21 01:46 PM

[TATyszka:]

It seems, if the whole small-cap universe rises an average of 82%, not only does the rising tide lift all the boats, but it also lifts a lot of trash off the bottom. It's those trashy stocks with sexy stories and/or ties to current fads such as alternative energy that set the speculative hearts all atwitter. Quality small-cap babies, such as those you mentioned, get thrown out in the same bathwater containing quality large-caps. I'm thinking it's when the long-term bullmarket is revived and investors flock back to quality that you'll see the likes of these two come alive. Suits me fine. I'm just a small investor happy for the chance to pick up some GXDX at its current level, which is about as low as its been since its IPO.

May 16 09:55 PM