Election Implications For Stock Investing: Promising Situation For Small Caps

by: Zacks Investment Research

The presidential election just ended and, regardless of how your choice fared, it's now time to comprehend what an Obama second term indicates for the stock market. It's always extremely difficult to get a bearing on the market's future and that is never truer than today, given the amount of uncertainty in the global economy. But, we can look to the past for clues on how certain types of stocks preformed after an election.

The analysis of Election Cycle investing has a long history dating, at least, from Herbst's and Slinkman's 1984 paper. They discovered that markets and political cycles do dance to a similar tune, which crescendos in November of the presidential election year. An often quoted study by Haung shows results are generally higher in the last two years of a presidential term when compared to the first two years.

The Handbook of Equity Market Anomalies summarizes most of the important studies regarding Election Cycle investing. The book also goes into much more detail than I have room for here, so I recommend that you read that section of the book. But the major point that Hensel and Ziemba (2000) discovered is that Small Cap stocks perform better than Large Cap stocks during Democratic administrations. The outperformance of Small Caps averages over 18% a year from 1929-1997. That's extremely dramatic and, as they prove, statistically significant.

Their research was updated through 2010 to include the majority of Clinton's second term, both of George W. Bush's terms and the first two years of Obama's first term. The 1998-2010 period also shows Small Caps outperform Large Caps during Democratic presidencies. But one thing that struck me the most was that most of the outperformance was captured within thirteen months after the election. So if history is going to repeat itself, it looks like Small Caps are going to have a pretty good year in 2013.

The Diamonds in the Rough

There are about 2200 Small Cap companies out there, so you're going to need to figure out the best way to capture the Small Cap Effect. You could always simply buy a Small Cap ETF, but what fun is that? Wouldn't you like to be able to find a way to select the best Small Caps yourself instead of simply buying the shrink-wrapped version in an ETF?

Well there is a tool that enables you to whittle those thousands of companies down to a manageable number. With our Research Wizard you can start with nearly 7600 companies at your disposal. You can then add filters to select stocks based on market value, numerous valuation and growth measures, price changes, the Zacks Rank and many, many more. But the best part about it all is that once you create a screen, you can then backtest it to see how it would have performed in the past. You'll be able to remove all the guess work and know what works in picking stocks and what doesn't.

A Small Cap Example

There's a Small Cap screen in the Anomalies folder in the Research Wizard, but, as a refresher, I'll share it below:

  • First, limit the stocks to only Small Caps by requiring a Market Value of at least $100 million, but less than $1 billion.
  • Next, create a liquid, investible set of the stocks with average daily trading volume greater than or equal to 100,000 shares and trading above $5/share (if there's not enough liquidity, it'll be hard for you to trade.)
  • Add another filter by selecting only those stocks with a Zacks Rank less than or equal to 2. (Any Zacks Rank 3 or greater is either at or under market performance.)

Here are five of the stocks that passed the screen this week (11/09/12):

SUNH - Sun Healthcare Group, Inc.

Sun Healthcare, through its subsidiaries, operates nursing centers providing nursing, rehabilitative and related specialty healthcare services principally to the senior population in the United States. This stock has a market value of $216 MM and is currently a Zacks Rank Buy. This company has had positive earnings surprises in six out of the last eight quarters. Sun Healthcare has been a hot stock this year, but its Price/Book, Price/Sales, and Price/Cash flows are all below market and industry averages.

HCI - Homeowners Choice, Inc.

Homeowners Choice, an insurance holding company, provides property and casualty insurance in Florida. The company provides property and casualty homeowners' insurance, condominium owners' insurance, and tenants' insurance to individuals owning property. This firm has beat earnings estimates in each of the last five quarters. The consistent positive earnings surprises have prompted analysts to increase future earnings projections. The combination of strong positive surprises and increasing estimates is the reason why this stock is a Zacks #1 Rank (Strong Buy).

CAMP - CalAmp Corp.

CalAmp is a leading provider of wireless communications products that enable anytime/anywhere access to critical information, data and entertainment content. This firm is the leading supplier of Direct Broadcast equipment to the U.S. satellite television market. This company has experienced positive surprises in the last six quarters. The stock price is up about 97% YTD, which has put a damper on its valuation, but profitability is high and debt is low at this $250 MM company.

LNDC - Landec Corp.

Landec designs, develops, manufactures and sells temperature-activated and other specialty polymer products for a variety of food products, specialty industrial and medical applications. This $269 MM company also has a strong history of exceeding earnings expectations. This Zacks Rank Buy is also rated as a Strong Buy by all four analysts that cover Landec. The stock price has been on a tear this year, but has seen a recent pull back, which often indicates a good buying opportunity.

BGFV - Big 5 Sporting Goods Corp.

Big 5 Sporting Goods operates as a sporting goods retailer in the western United States. The company offers athletic shoes, apparel, and accessories, as well as a selection of outdoor and athletic equipment for team sports, fitness, camping, hunting, fishing, tennis, gold, snowboarding, and roller sports. As we all know, a stock's price tracks corporate earnings and Big 5 is a perfect illustration of this concept. The stock of this company rose when it beat estimates in six out of the past seven quarters. And now, analysts have been raising earnings expectations for the remainder of this year and next year as well.

A Promising Situation for Small Caps

Because research has shown that Small Cap stocks perform well, on average, during Democratic presidencies, 2013 bodes well for those interested in a Small Cap investing style.

Read the full analyst report on SUNH/Read the full analyst report on LNDC/Read the full analyst report on HCI/Read the full analyst report on CAMP/Read the full analyst report on BGFV (email registration required)