Nine Winning Trades For 2009

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Trade #3: Buy Small Capitalization Stocks

Small cap stocks tend to be equity financed rather than debt financed.  Although this is not an attractive time to raise growth capital through equity (2008 had the fewest number of initial public offerings since 1979), many of these companies do not have meaningful levels of long-term debt.

Maybe more importantly as we move toward the inflection point of bad to less bad, investors typically buy small cap stocks to capture the highest sensitivity to an economic recovery.

Mebane Faber of Cambria Investments writes about the outperformance of small cap stocks in the wake of “really bad years” in the market. 

He writes: “A simple system of holding the smallest 20% of stocks every January since 1927 results in returns of around 10% a year (and that is without sitting in cash the remaining 11 months of the year which would add an additional 3.5% per annum to returns). That dwarfs the 1.5% return for the largest 10% of stocks in January."

"What about investing in small cap stocks in January following a terrible year for stocks? In this case I examined all of the years back to 1927, took the 10 worst years in stocks, and examined how small caps (bottom 20% by market cap) performed the following January. The average performance for the S&P 500 the year prior was -21.22%.

The results?  An astonishing average performance of 18.17% per January with the worst year being a positive 2.2% (2003). Adding in cash returns the following 12 months and you have returns over 20%.  The average performance of the large caps (top 10%) in January of those years would have been a paltry 3.1%.”

Trade #4: The Strong Will Get Stronger