Is the January Effect Worth Considering?

 | Dec 27, 2011 | 10:00 AM EST
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January is nigh upon us and with it, inevitably, comes a discussion of the January Effect, which is the phenomenon of stocks tending to rise in the first month of the year.

Stocks don't always rise in January, though it seems that many times they do. No one has proven conclusively why this is, but an often-stated reason is that small-cap stocks are behind this phenomenon. The thinking is that small-caps go up in the first month of the year because individual investors have sold stocks in December for tax reasons, which pushes down prices, and then re-enter the market in January, pushing up the stocks they are buying. And they tend to trade small-caps.

In truth, I am skeptical about the January Effect, but I do believe smaller stocks, particularly those that have done poorly in recent months, could be in a good position to go up, especially if they have solid financials.

I decided to look for such stocks. I define small-caps as those with a minimum capitalization of $500 million (which is the minimum threshold at Real Money to assure sufficient trading liquidity) and a maximum capitalization of $1 billion.

One such company is MWI Veterinary Supply (MWIV), which distributes animal health products, including pharmaceuticals, equipment, supplies and food to veterinarians. Its market cap is about $850 million. Its stock started the year at about $65, got as high as $90.24 and is now back down to about $67.

Among the automated strategies I use to choose stocks is one I based on the writings of James P. O'Shaughnessy, which likes MWI. This favorable analysis is a result of the company's market cap, consistently growing earnings per share (which has increased in each of the past five years) and a very favorable price-to-sales ratio of 0.54 (up to 1.5 is acceptable). Among the stocks that pass these first three variables, the strategy seeks out the top 50 stocks based on their relative strength, which is a measure of how well a stock has performed over the past year relative to the market. MWI's relative strength of 69 puts it in this top 50 group.

National Presto Industries (NPK) is another stock that's well positioned for the January Effect or, if you don't believe in the Effect, is well positioned for a move up, in any case. Its market cap is $670 million, and the stock, since peaking at $137 early in the year, has been on a long slide, though in recent months it has stabilized in the $83 to $100 range, and recently closed at around $98. The company manufactures small kitchen appliances, housewares and other products under the Presto name.

My Peter Lynch based strategy thinks National Presto is cooking on all burners. This strategy particularly looks at the PEG ratio, which is price-to-earnings relative to growth and a measure of how much the investor is paying for growth given the stock's current price. The company's PE is 11.80 and its growth rate is 26.83%, based on the average of its four- and five-year historical EPS growth rates. This gives it a PEG of 0.44, which is very favorable. In fact, a PEG of 0.50 or less is considered extremely strong. Another big plus: NPK has zero debt.

Also consider Greatbatch (GB). Its market cap is $520 million and the stock trades at about $22, where it has been hovering for the last few months after reaching a high of about $29 in late May. The company, which made its name in the heart pacemaker market, makes batteries and capacitors, among other products used primarily in medical devices. The Lynch strategy is keeping pace with Greatbatch. Like National Presto, Greatbatch's PEG is very strong -- 0.47 based on a PE of 12.66 and a growth rate of 26.8%, based on the average of the three-, four- and five-year historical EPS growth rates. And debt is at a reasonable level.

I am not suggesting loading up on stocks right now because the January Effect is likely to kick in -- maybe it will, maybe it won't -- but these companies are worth buying whatever the season.



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