We constantly read about stock market phenomena that occur that create a unique investment opportunity. One that caught our eye last year was the January Effect, and we were hoping that it would prove true as the market had already fallen off following the financial meltdown in September of 2008.
However, the January effect only materialized in part, as we witnessed nearly a 10% drop in the month of January 2009, marking the second consecutive year the January Effect has not been very effective. However, the market was up overall for the full year. The January Effect is a theory that says the stock market tends to rise the month of January as investors are buying up stocks, due to recently selling before the end of the year for tax purposes. The January Effect also notes that small cap stocks tend to outperform large cap stocks. This theory was first discovered by a Univ. of Chicago grad student Donald Keim in the 1980’s.
The part of the theory that small cap stocks tend to outperform large cap stocks has held true many times throughout history (only 6 years since 1980 did large caps outperform small caps 1982,1987,1989,1990 and 2008, 2009). One criticism of this strategy is that it is difficult to profit from this theory because the market expects the January Effect to happen and prices adjust accordingly.
Another part of the theory is that the performance of the market in January, especially the first five days, is used as a predictor and will set the trend for the performance of the market the remaining eleven months of the year.
- 85% of the time the S&P 500 has seen a rise the first five days of the year, the index has followed suit the remainder of the year.
- 32 of the last 39 years the performance of the S&P 500 has followed the direction of the index in January for the following 11 months.
Recap of 2009:
First five days the market was down (2009 The Market Closed Up)
Large cap stocks outperformed small cap stocks (It may be coincidence or it may be a trend but the last two years large caps outperformed small caps)
In this exercise we will take a list of small cap companies that we released last week (7 out of 10 are up so far and the group as a whole has currently outpaced the Russell 2000 by 2.88%) that look undervalued from a valuation standpoint and track the performance through January to see if the small caps we find attractive will keep with the trend. If small caps are most likely to outperform and VE believes that these 10 firms are the most likely to outperform from the Russell 2000, then this is a list you may want to consider as potential investment opportunities.
As a further layer of analysis the chart below is an example of The Applied Finance Group's (AFG’s) proprietary Intrinsic Value Chart which provides insight into how well AFG has tracked the company through time and how the company currently fares according to AFG’s default valuation model. The company example we are providing is Imperial Sugar Company (IPSU), one of the small caps companies from last week’s list that AFG has tracked well and looks undervalued. Also provided below is a map of the components of the Intrinsic Value Chart as well as how to interpret the chart and the important things to look for.
We will revisit these companies in February to see how they fared vs. large caps and to see what the overall performance of the market in January will predict for 2010.
AFG’s Intrinsic Value Chart:
• Identifies entry/exit points
• Shows how well AFG has tracked the company (accuracy)
• Displays the trading range of the company each year through time (blue bars)
• Displays the end of year closing price (dash on blue bar)
• Displays AFG’s default intrinsic value (red dotted line)
How to Read this chart:
• The Blue Bars represent the high and low trading range for a stock for each calendar year.
• The red dotted line represents Applied Finance Group’s (AFG’s) historical Intrinsic Value through time.
• When the red line (Intrinsic Value) is above the blue bars (trading range) the company looks to be undervalued.
• When the red line (Intrinsic Value) is below the blue bars (trading range) the company looks to be overvalued.
Below is an example of AFG’s Intrinsic Value Chart and the important things to look for within the chart.