Look to Small-Caps for Big Winners

 | Feb 17, 2012 | 10:30 AM EST
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In the world of stock market investing, small is typically beautiful. Consuelo Mack, in a television interview with noted small-cap mutual fund manager Chuck Royce, made the observation that the Russell 2000, which is largely made up of small-cap companies, has outperformed the S&P 500 over the last three-, five- and 10-year periods.

This mirrors the performance of the S&P SmallCap 600, which was up 8% annually in the last decade vs. a 0.8% gain for the S&P 500 in the same period.

The stellar performance of small-caps has gotten some to think that the future belongs to large-caps. Small-caps, so the thinking goes, have run their course, and in the near to medium term, large-caps will shine.

Others are not so sure. The Wall Street Journal recently quoted an observer who commented, "Small-caps are bull-market investments; they are going to respond better than the average stock in a market and economic rebound." The economy seems to be strengthening, which would indicate the strength in the market will go to small-caps.

Of course, market timing, as I have noted before, is a fool's game. However, it is worth noting that over time, small-caps have generally outperformed large-caps. Plus, the guru strategies I follow are also positive about these stocks.

The guru strategies are computerized strategies I created based on the writings of some of Wall Street's great investors. There are a number of small caps (market caps of up to $1 billion) that get high grades from not just one guru strategy, but two. These are worth paying attention to now.

One is MWI Veterinary Supply (MWIV), which has a market cap of $884 million. This company distributes animal health products, including pharmaceuticals, equipment, supplies and food, to veterinarians. It carries more than 30,000 products and its customers include more than 20,000 veterinary practices. Americans love their pets, which keeps the veterinary market strong.

For this one, I based the strategy on Peter Lynch's writings, as he likes MWI because of its P/E/G ratio of 0.94. This ratio, which looks at price-to-earnings relative to growth, is a measure of how much the investor is paying for growth. To be acceptable, the P/E/G must be 1.0 max, and MWI's is just below this.

But the Lynch strategy is not the only one barking loudly in favor of MWI. My James P. O'Shaughnessy strategy likes this company's market cap, earnings (which have increased in each of the past five years), low price-to-sales ratio of 0.65 (1.5 is the maximum allowed) and relative strength. Overall, MWI is a small-cap company that is performing well, has a history of steady earnings growth and whose stock is reasonably priced.

Another small-cap worth taking a look is a health care company that services the human medical market -- Bio-Reference Laboratories (BRLI) whose market cap is $634 million. This is a regional clinic laboratory that performs such tests as blood and urine analysis, toxicology, pap smears and biopsied-tissue examinations. Located in New Jersey, the company says it is the largest independent clinical lab in the Northeastern market and the third largest full-service lab in the U.S. Like the veterinary market, the human medical market is strong and looks likely to remain so for the foreseeable future.

My Buffett- and O'Shaughnessy-based strategies strongly support Bio-Reference. The Buffett strategy likes the company's strong market position, earnings consistency (earnings per share have increased in nine of the past 10 years), low debt, strong return on equity (16.9% over the past 10 years) and projected annual rate of return to investors 17.4% over the next decade.

The O'Shaughnessy strategy likes the company's market cap, earnings which have increased in each of the past five years, price-to-sales ratio of 1.39 and relative strength.

The last small cap I'll mention is Rue21 (RUE), whose market cap is $829 million. Rue21 is a specialty-clothing retailer catering to the younger set of both men and women. It proudly proclaims it offers "fashion at a value," which let's you know its marketing strategy. It has 638 stores in 44 states. It is in a competitive market, but is doing well and seems well managed, witness is lack of any debt.

As with MWI, Rue21 is liked by the Lynch and O'Shaughnessy strategies. Its market cap, consistently increasing earnings, price-to-sales ratio and relative strength are what make Rue21 a favorite of the O'Shaughnessy strategy. The Lynch strategy likes the company's P/E/G of 0.86 and absence of debt.

These three small-cap companies get high marks from two strategies. All of these companies are doing well and have reasonably-priced stocks. Even if small-caps in general don't perform in the near to medium future as they have recently, these stocks should do just fine. And if small-caps continue to outperform large caps, these companies could be major winners.



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