Why Third Quarter Results Say Buy Small Companies Now

by: Tyler Laundon

I wrote on Monday in The Only Investing Strategy That Always Works that the market could still go down from here. But that article also suggested that it's a great time for long-term investors to add equity exposure, with one caveat - buyers have got to be comfortable with the market's volatility.

I don't expect that many people took my word for it. It's always tough to buy stocks when you should - just like it takes guts to be the first person to jump into the ocean after a shark attack, even in places where those are rare events.

But as they say, fortune favors the brave.

As I wrote Monday:

When stocks do recover it will be the smaller companies that will provide the biggest gains. These will be in the double and triple digits, and it will be hard to not make money if you own shares of solid small companies. But you can't wait until the market gives the 'all clear' sign - because it will never come.

I wasn't just throwing these strong words around. History suggests that small cap stocks will rise in the fourth quarter. The numbers are pretty convincing.

With a little help from Credit Suisse's Quant Research group and Russell Investment's website, I crunched some quarterly data going back to 1980.

The first four bullets are an overview of what worked (very little) and what didn't (nearly everything) in the third quarter.

  • The third quarter of 2011 was the 4th worst on record for small caps which fell by 22 percent.
  • All nine sectors of the Russell fell, with energy, technology and materials especially hard hit.

Russell Sector Performance as of September 30, 2011

Russell Sector Performance as of September 30, 2011

  • Bigger was better (according to market cap) in the third quarter, even within our relatively small asset class. Companies without positive EPS were especially hard hit.
  • Dividend payers ruled, especially during periods of extreme weakness.

The above is the classic risk-off trade. That was the bad news for those who were long small and micro cap stocks.

This pain does have an apparent remedy. Time - and we're not talking years. That's the good news, and the basis for my statement that adding small cap exposure now is worth the attendant risk.

Consider the following:

  • In the thirteen worst quarters for the Russell 2000 (dating back to 1980) the index has been positive in eleven of the subsequent quarters. It has been flat in just one and down in only two, in 1982 and 2008. The average return in the thirteen subsequent quarters has been 7.9 percent.
  • Six of these thirteen 'worst' quarters occurred in the third quarter, yet in all six instances the Russell 2000 has never been negative in the fourth quarter (it was flat once). The average return has been 9.3 percent.

These are compelling stats from Credit Suisse and tell me to buy small cap stocks first, and ask questions later. We all know that past performance is not a guarantee of future results, but, on the other hand, history does have a way of repeating itself, as the above statistics show.

It's always good to temper enthusiasm with a healthy dose of reality before entering stock orders however. And the biggest downer right now is that between October 1st and last Thursday's close, the Russell has already moved 14.7 percent higher. While I appreciate the market's support on my call to buy stocks Monday, this move suggests that the index will be flat for the remaining part of the quarter.

So I'm not taking the above data as a fool proof sign that it's time to jump into the market with everything I've got today, and neither should you.

But is it a time to add a little exposure? Heck yes. And it's the individual stocks that risk-tolerant investors should be looking at. These are the ones that were hurt the worst during the third quarter, and have yet to fully recover. As always, average into positions, and only invest money that isn't needed for at least a few years, preferably five or more.

I know names are important. To support my points check out eMagin Corporation (NYSE: EMAN), up 73 percent since the end of the third quarter, Patterson-UTI Energy (Nasdaq: PTEN), up 17 percent and Pioneer Drilling (AMEX: PDC), up 37 percent. I don't own any of the above.

Stocks that I did purchase shares of last Thursday include small cap FX Energy (Nasdaq: FXEN), the Market Vectors Junior Gold Miners ETF (NYSE: GDXJ), and large cap Novo Nordisk (NYSE: NVO), which pays a modest dividend, as well as a small oil services company that I won't name.

The various reasons for owning any of the above are naturally dependent on individual investor strategies, preferences, time frames and so on. Mine are sure to be different from yours.

Eventually, company specific fundamentals will drive share price performance. Buying shares when fundamentals have been tossed out the window, as in recent weeks, just makes good sense to me. It should to you too. Already, it appears that fundamentals are beginning to matter again. That's a positive sign.

Has the market bottomed? Who knows - cheap stocks can always get cheaper. And the past week could prove to be just a short-term bounce in an emerging bear market.

But the the risk-reward profile of many small companies right now is extremely compelling - far too compelling to pass up.

Disclosure: Author owns shares of FXEN, GDXJ, and NVO