Investment advisers with some of the best returns this year have something in common: an appetite for small stocks that most others have passed over.
They also harbor an aversion to bigger, fast-growing companies whose shares are expensive — many of which faltered in March and early April when investors bailed out of high-flying technology and biotechnology stocks.
Focus on investing
Of the nearly 200 stock-focused advisory services monitored by the Hulbert Financial Digest, the 10 with the best returns through Thursday produced an average gain of 11.9%. That contrasts with 2.3% for the S&P 500 (.SPX) and minus 0.7% for the Nasdaq Composite Index (.IXIC). (These returns assume dividends were reinvested.)
The 10 services are the Bowser Report, edited by Thomas Rice; the Christian Transportation Investor and the Christian Utility Investor, both edited by Mick Williams; the Complete Investor, edited by Stephen Leeb; Contrarian's View, edited by Nick Chase; the Forbes Low Priced Stock Report, edited by Marc Gerstein; the Forbes/Wolfe Emerging Tech Report, edited by Josh Wolfe; Hidden Values Alert, edited by Charles Mizrahi; New World Investor, edited by Michael Murphy; and Nate's Notes, edited by Nate Pile.
The services, which construct model portfolios for clients to mimic, charge annual subscription fees as high as $495.
Not all of these advisers focus exclusively on the small-cap value sector. But the consensus view right now among a majority of them is that this is where you are most likely to find stocks offering the potential for big gains.
Why? Simple: Small-cap stocks — those with market capitalizations less than around $2 billion — offer more opportunity for big gains than do larger stocks, several said in interviews.
That partly is because larger stocks are followed by so many analysts that it is harder to discover a hidden gem in their ranks.
When small caps shine
The Bowser Report's Rice, whose average model portfolio has gained 13.6% this year, cites another reason: timing. Small-cap stocks often begin to shine only after a bull market is well advanced.
"In the earlier stages of a bull market, people favor the larger blue chips," he says. "Only as the bull market continues do investors begin to look further and further down the market-cap rankings. That's when the new money entering the market trickles down to the lowest-priced stocks."
One of Rice's recent picks is Century Casinos (CNTY), which operates midsize casinos around the world. The stock has gained 14% so far this year.
A lot of 'junk'
The small-cap sector also contains a lot of "junk," says Gerstein of the Forbes Low Priced Stock Report, making it imperative to focus on the highest-quality stocks — those that have strong balance sheets as defined by factors such as generating surplus cash and buying back shares.
Yet many investors unfairly shun these high-quality companies because they haven't yet grown large enough to produce handsome profits, he says. Instead of relying on earnings-based valuation measures — such as the price/earnings ratio — Gerstein prefers others, including the price/sales and price/book ratios.
The year-to-date gain of Gerstein's model portfolio is 8.7%. One of his latest picks is Frontier Communications (FTR), which provides telecommunications services to rural areas and small and medium-size towns. It has risen 27% so far this year and trades at a price/sales ratio of 1.2 and a price/book ratio of 1.4, compared with 1.7 and 2.6 for the S&P 500, respectively. (The ratios are calculated by dividing price by per-share sales and book value, a measure of net worth.)
Gerstein is selective, saying he doesn't think the small-cap sector as a whole is a good buy right now. He thus doesn't recommend investing in it via mutual funds or exchange-traded funds because they tend to be benchmarked to the average stock in the entire sector.
As represented by the Russell 2000 Value index, the small-cap value sector's year-to-date return is 0.5%, versus 1.1% for the Russell 1000 Growth Index, a proxy for the large-cap growth sector. Last year, the two indexes returned 35% and 33%, respectively.
Of the 10 best stock-oriented advisers this year, just one — Nate Pile of Nate's Notes — has a monitored track record over the past decade and beaten the market over that period. His service has produced a 21% year-to-date gain, and over the past 10 years has delivered a 13.5% annualized return, versus the S&P 500's 7.5%.
Though Pile recommends that his clients build up a little cash, he also said via email that he will remain bullish on stocks as long as the five major indexes he follows continues to stay above key "support" levels. The index that is closest to falling below its level is the S&P 500; Pile's trigger for it is 1,816, or 3.3% below current levels.
One of Pile's favorite stocks right now is MannKind (MNKD), a biotechnology company that he likes as a bet on its inhalable insulin product, which is in late-stage clinical trials. Its stock has gained 23% year to date.
In addition to favoring small-cap value stocks, several of these top performers also are placing strong bets on precious metals. Pile says he is "extremely confident" that buying gold at current levels will "end up looking like a very smart move" over the next decade. Murphy also is bullish on gold, though he cautions that precious-metals investors need to focus on the longer term since he thinks gold could fall over the next few months.
Pile's preferred gold investment is the SPDR Gold Trust ETF (GLD), with a 0.40% annual expense ratio, or $40 per $10,000 invested.