The January Effect And Your Portfolio

Includes: DHX, MED
by: John P. Reese

December is the month for gift giving, but historically the stock market has given investors the greatest gifts in January -- and they've come in small packages.

Studies show that over the long haul, January has by far been the best month for stock returns, with small stocks driving most or all of the outperformance. Researchers began to dig deeper into this seasonal anomaly in the 1970s, initially finding simply that stocks in general produced higher returns during the first month of the year. Then they realized that the effect was concentrated in smaller stocks, and then that it really seemed to be at play for small firms whose stocks had declined in the previous year. Behavioral finance pioneer Richard Thaler noted in a 1987 paper in Economic Perspectives ("Anomalies: The January Effect") that the effect was observed not only in the U.S., but in many other countries as well. Part of the phenomenon seemed to be related to tax-loss selling -- investors would sell losing positions in December as tax write-offs, artificially driving down prices of those shares; smaller stocks were less able to absorb the blows and thus hit harder. Then in the new year bargain hunters would pounce on them, resulting in bounce-back gains.

The effect appears to go beyond tax-loss selling, however, Thaler said, noting that the January Effect was observed in countries that had no income tax, or which had tax years that started in months other than January. MarketWatch's Mark Hulbert has hypothesized that one reason involves mutual fund managers loading up on larger, steadier stocks late in the year rather than smaller, riskier stocks, not wanting to risk a short-term period of underperformance that could taint their year-end returns. Then, with a clean slate in the new year, they buy up small stocks again.

Whether it's tax-loss selling, fund manager tinkering, a renewed sense of optimism and risk taking that comes with the New Year, or some combination of those and other factors, the January Effect has a long track record. It doesn't occur every year, however, so I don't advise loading up on small stocks without regard to other factors. But, if you are thinking of tilting your portfolio toward small-caps, I'd advise focusing on those that have strong fundamentals and financials -- that way the January Effect becomes a bonus, not something you're relying on.

With that in mind, I recently used my Guru Strategies (investment models that are each based on the approaches of a different Wall Street great) to find some cheap, high quality small caps that could benefit from the January Effect. Here are two that looked particularly intriguing.

Dice Holdings, Inc. (NYSE:DHX): This New York City-based small-cap ($400 million market cap) provides specialized job search websites and career fairs for employers and prospective employees. Its shares have fallen about 5.6% in the last month, and are down about 24% for the year, thanks in part to a couple disappointing earnings announcements. But the firm has a free cash flow yield of about 10% and it has been pursuing an aggressive share buyback program that should help give shares a boost. The stock gets strong interest from the model I base on the writings of mutual fund legend Peter Lynch. Lynch love fast-growers, and with a long-term EPS growth rate of 34.7% (using the average of the three- and four-year EPS growth rates), Dice fits the bill. Lynch famously developed the P/E-to-growth ratio to find undervalued growth stocks, with the idea being that you should be willing to pay a higher valuation for a stock that is producing more growth. PEG ratios below 1.0 are acceptable to this model, with those below 0.5 the best case. When we divide Dice's P/E ratio of 13.6 by its growth rate, we get a stellar 0.39 PEG.

Lynch also liked conservatively financed firms, and this model calls for stocks to have a debt/equity ratio below 80%. At about 32%, Dice easily makes the grade.

Medifast, Inc. (NYSE:MED): This Maryland-based firm ($350 million market cap) offers weight-loss programs through which customers can purchase low-fat protein and fiber meals fortified with vitamins and nutrients, as well as support programs.

Medifast shares are down about 3% this year. But like Dice, its fundamentals are strong (and, like Dice, it has been pursuing an aggressive share repurchasing plan). The stock is another favorite of my Lynch-based model. It has grown earnings at a 30% clip over the long haul (using an average of the three-, four-, and five-year EPS growth rates), and trades for 17.3 times earnings. That makes for a very solid 0.57 P/E-to-growth ratio. In addition, it has a debt equity ratio below 1%.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.