Small-cap value stocks have consistently outperformed all other categories of stocks.
That's the message coming from the industry's most respected academic and financial institutions.
Small-cap value stocks outperformed the general market by 4.3% annually from 1926-1997, according to Morningstar's registered investment adviser subsidiary Ibbotson Associates. Leading investment firm Vanguard has also published research showing that small-cap value outperformed large-cap value, blended and growth portfolios from 1927-2004.
But it's not just a generally bullish trend that has carried this group. University of Chicago finance professors Kenneth French and Eugene Fama of the popular French-Fama asset pricing model -- a valuation strategy that looks for small-cap stocks that are in value territory -- concluded that small-cap value stocks outperformed other classes during recessions as well. Another report by Fund Evaluation Group highlighted how small-cap value has outperformed all other groups by a wide margin.
This trend has been on display in the past 12 years. The chart below and shows how the iShares Russell 2000 Index (IWM) of small cap stocks has destroyed the major averages, returning 85% to the S&P 500's 3% loss.
There are two reasons why small caps offer the potential for such large returns. The first is just a simple matter of math, where companies starting from a base of lower sales and operations have opportunity to grow many times over. This is basically like the power of compounding on steroids.
The second factor is imperfect information. Unlike large caps, which can have as many as 25 covering analysts creating research reports, information on small caps is harder to come by. Although this might seem annoying because investors like information about stocks and markets, it creates a big opportunity. Less information, analysis and coverage frequently leads to shares being over or under valued.
Applying the Fama-French model and looking for strong earnings and earnings growth is a great way to separate the winners from the losers.
With this in mind, here are three top small-cap value gems I found...
1. CARBO Ceramics (NYSE: CRR)
CARBO is a basic materials company in the energy services industry with a market cap of $1.7 billion. The company specializes in developing and manufacturing ceramic propant, a substance that drillers use in the extraction process of natural gas commonly referred to as "fracking." Much like the general weakness in energy stocks, Carbo's share price has fallen more than 50% in the past year.
While that may be a setback for current shareholders, the valuation has rarely looked better. With a forward price-to-earnings (P/E) ratio of 13, returning to the average of 24 in the past 10 years would have shares of Carbo up 90% from current levels.
2. Impax Labs (Nasdaq: IPXL)
This generic and branded drug maker has a market cap of $1.5 billion. The company specializes in drugs for central nervous system disorders, Alzheimer's disease, attention deficit disorder and Parkinson's disease. Impax recently reported excellent second-quarter results that included a 36% upside earnings surprise.
Analysts were quick to upgrade their earnings projections, with the full-year 2012 estimate jumping 15% to $2.05. But in spite of those gains, shares only trade for 13 times forward earnings. If Impax returned to just its average valuation of the past 10 years. then shares would jump 34%.
3. Coeur d' Alane Mines (NYSE: CDE)
Coeur d' Alane is a silver miner based in Idaho with mining assets in the United States, Mexico, Bolivia, Argentina and Australia. In spite of the price of gold holding in elevated territory, gold stocks have performed terribly in the past year. With Coeur d'Alene trading just above $21, shares are well off the 52-week high of $30.99.
This probably has a lot to do with weakness in the current-year estimate, falling 69 cents in the past 90 days to $1.26 per share. But longer-term, the next-year estimate still looks great, pegged at $2.63, a bullish 108% growth projection. That is a big opportunity for investors taking a longer-term view.
Risks to Consider: Small-cap stocks are known for extreme volatility. Although many small caps grow into mid- and large-caps, there are plenty of others that fail or go out of business. Investors buying small-cap stocks should be ready for short-term volatility in order to have a chance at outsized gains in the long run.
Action to Take --> These three undervalued small-cap stocks are in position for big long-term gains as each company advances through early and medium stages of growth. Investors who are not afraid of some volatility should snap up shares while they're still cheap.
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