The Key to Profiting with Small-cap Stocks

by George Leong, B. Comm.

The major market indices broke back above the key breakout levels on Monday. While this is a positive sign, we still need to see some sustained buying surface in order for stocks to trend higher. My feeling is that markets could move sideways in the near term until we see more concrete evidence of economic renewal in the U.S. and globally.

A problem area continues to be the housing market. It remains dismal, with record home foreclosures and late payments at a record in the first quarter and expected to continue but stabilize. The housing building permits report for April was a record low. There have been some encouraging signs with home-building supplies company Lowe’s Companies, Inc. (NYSE/LOW) reporting a strong quarter on Monday and rival The Home Depot, Inc. (NYSE/HD) on Tuesday. It appears that homeowners are having more confidence at least to fix their existing homes due to the record reduced interest rates; but, for the economy to improve, there must be strength in the housing building and sales market.

While the economy is still stalling, there will come a time when the GDP begins to edge higher. This may happen as early as later this year with some small growth, but it appears to be more likely to be 2010 when the GDP will show more strength. A key benefactor of an economic reversal will be small companies, which trade in correlation with the economy.

I’m a firm supporter of buying growth in small companies for the long term. There has been some optimism in the small-cap sector, as the Russell 2000 recently broke back above 500 prior to some subsequent profit-taking. The rebound in small-cap stocks has been driven by improved optimism that the U.S. economy may improve later this year.

My feeling is that small-cap stocks will continue to outperform in the longer term. The historical statistics reflect this. Short-term trading gains could also be spectacular when the economy rallies.

The key for you as an investor or trader is to monitor a group of small-cap stocks that you like and pick up or add to a position should the stock decline significantly. If you had done this in February or early March, you’d be sitting on some significant gains. Also look to invest in small companies in both the U.S. and Canada, along with other key global growth regions such as China, India, Asia, Brazil, and Eastern Europe. As long as you are diversified, you will be fine.

An example of a China-based small company that has made significant short-term profits is China Security & Surveillance Technology, Inc. (NYSE/CSR). This stock fell to a 52-week low of $2.47 on March 12, but has since been accelerating higher. It traded at $8.99 on May 7, up a remarkable 264% in about two months or an annualized return of about 1,564%. These types of situations occur more frequently than you may think, but you need to monitor the market closely on a daily basis and be ready to take advantage of trading or investing opportunities when they appear.