Saturday, June 30, 2012

3 Keys to Playing the Underground Small-cap Rally

It takes just ten minutes to prepare for a major market rally. By following my three simple steps, you can quickly find a handful of small-cap stocks that will outperform the market over the next 3 months.

But before I reveal my screen criteria, I want to show you why I believe we�re entering an important moment for small stock investors…

Right now, the market is beginning a powerful underground rally, boosting small-cap stocks close to their pre-correction highs. The Russell 2000 is up more than 11% year-to-date, easily topping large-caps in the S&P 500 and the Dow.

Small-caps are winning the race right now because they are the most potent stocks to own during the early stages of a rally. As you probably know, investors see small-caps as riskier investments. That�s why they are the first to be sold off after a long bull market.

But small-caps are also the first stocks to rise once the market has bottomed out. The rush to get back into smaller names pushes these same stocks up farther and faster than their larger counterparts.

Even though small-caps are outperforming the S&P 500 and the Dow so far this year, we haven�t seen a watershed buying moment just yet. That�s why I�m still calling this an �underground� rally. But with every passing day, I think we�re getting closer to that powerful breakout. All that�s left to do is to coax investors on the sidelines back into small stocks.

Retail investors have pulled almost $18 billion out of small-cap funds over the 36 of the last 39 weeks, according to data from J.P. Morgan. This shows us that a great deal of Main Street�s money is still in cash, waiting until the investing waters are declared safe before buying smaller stocks. All we need is volatility to remain low and the market to remain stable for these market watchers to dive back into stocks.

That�s where my 3-part screen comes into play. Follow these easy steps, and you will be able to track down the small stocks that are the best candidates to beat the market. If you do it today, you�ll even have the chance to get in on these names before the next leg of the rally begins to take off…

To begin, go to your favorite free financial website. Google Finance, Yahoo or any of the other major sites will do. If you want a more comprehensive list of screening tools, just search for �stock screeners� online. There are plenty of viable options out there. You don�t even need a subscription or any special software.

[Editor�s note: For a more in-depth piece on free stock screening sites, click here.]

Now you�re ready to begin your search.

1. First, drill down to the most viable sectors: Right now, the investing environment is most suited for consumer stocks, tech names, and pharmaceuticals. These are the types of small-cap stocks that are looking strong right now. Get rid of stocks in the utilities, energy and financial sectors. These are the names that aren�t showing strong earnings or growth at the moment. There�s no point in wasting your time sifting through stocks in a lagging sector. Cut them, and move on.

Setting up the screen is simple. Just adjust your market cap parameters to find stocks in the $300 million – $2 billion range. Then you can enter your sector of choice…

2. Find the profitable companies trading at a low price-to-earnings ratio: The next metric you need to add is price-to-earnings ratio. Investing in companies that are cheap compared to how much money they are earning is a great way to prepare for a rally. Filtering out stocks with P/E ratios higher than 15 is the perfect way to narrow your search. When stocks are moving higher, bargain hunters will swoop in and bid up these �cheap stocks� to more reasonable levels.

Now that you�ve added this second key metric, you can begin searching your selected sectors for cheap plays. Make a list of all the companies that interest you. Now you�re ready for the final step…

3. Finally, select the stocks with the most momentum potential: Your final step involves some quick chart analysis. But don�t worry�you do not have to be seasoned market technician to complete this task. Simply take your list and look at each company�s daily chart. Then ask yourself one simple question: What is the primary direction of this stock?

There are three answers to this question: up, down, and sideways. Get rid of any stock that looks like it is moving lower. That will leave you with names that have bottomed out and are moving sideways, and stocks that are moving higher. As you narrow your list, you can use these charts to separate your best ideas. If you have two stocks you really like, compare charts. Unless you have a compelling reason to pick one name over another, I would recommend going with the stock in an uptrend every time.

Here are a couple of examples I found after searching for only 10 minutes:

Iconix Brand Group Inc. (NASDAQ:ICON): Iconix owns a large portfolio of apparel brands. Its P/E comes in at about 13, and the company has proven it can steadily increase its sales and earnings. The stock has also moved steadily higher since it bottomed in early October.

Greatbatch Inc. (NYSE:GB): Greatbach is in the medical device sector. Its P/E comes in at 14. The stock is also only slightly above sales�another sign of a cheap name. GB is also recovering from last year�s slump. Shares are quickly approaching pre-correction highs.

Of course, this lightning-fast analysis just scratches the surface of these two companies. Still, you can see how a quick search yielded two strong possible investments.

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