10 potential small-cap rockets

By Harry Domash

We're approaching one of the best times of the year to be in the market, especially for small-capitalization stocks.

The Russell 2000 Index ($RUT.X), which tracks stocks of smaller companies, has gained 9%, on average, from Oct. 15 through Dec. 31, over the past 11 years. What's more, the index recorded a loss in only one of those years (1997).

But buying small-cap stocks calls for a different strategy from investing in large blue chips, which some investors hold for years. For small stocks, a momentum strategy might be more appropriate.

Momentum investing involves picking stocks of companies whose earnings are growing quickly and accelerating, and whose stock-price charts show strong upward momentum. So-called momentum investors ride these rockets until something goes wrong. Then they sell at the first sign of problems.

Despite their heavy use by hedge-fund managers and other pros, momentum strategies don't get much attention from TV pundits and market gurus. When they do, it's usually in a negative context, such as "the momentum crowd drove the price of XYZ stock up to a ridiculously overvalued level."

But my research shows that in a strong market, momentum-stock-picking strategies work, especially for small stocks. Watch out, though; that caveat about a "strong market" is very important.

Seasoned investors know that, in the stock market, every year is different. So, despite my research showing that mid-October through year end is a great time to be in small stocks, this could be the year that's different.

First, I'll describe my screen for finding momentum-stock candidates. Then I'll show you how to see whether the time is right for buying stocks turned up by the screen. Here's a link to the complete screen. You can run it as is or modify it to suit your ideas.

I'll start by isolating a universe of stocks worth considering.

Keepin' it small

Market capitalization (recent share price multiplied by the number of shares outstanding) is the way most investors measure company size. Market cap is how much money you'd have to come up with to buy all of a company's shares. Definitions vary, but I'll define small caps as stocks with a maximum $2 billion market capitalization.

Screening parameter: market capitalization <= 2,000,000,000

No penny stocks

The term "penny stocks" typically refers to stocks trading for less than $5 per share. These cheap stocks are appealing because, on the surface, they appear to offer better odds of making a big killing, say doubling or tripling, than do more expensive stocks.

However, these stocks are cheap because most investors are shunning them, usually because they see serious fundamental problems. In my experience, most cheap stocks are more likely to head down than up.

Thus, to minimize risk, I rule out stocks trading for less than $5. Some investors even consider stocks trading at that level as too risky. If you're in that camp, consider hiking the minimum trading price to $10 or even as high as $15.

Screening parameter: last price >= $5

In good company

Trading volume is the average number of shares traded daily over a specified period, say over the past month. For most stocks, hundreds of thousands, if not millions of shares, change hands daily. Stocks with very low trading volumes are bad ideas. Here's why:

As you've probably already discovered, many folks posting on stock message boards have an agenda, either to push a particular stock price up or pull it down. They have better chances of success in those endeavors by focusing on low-volume stocks where their messages could stimulate enough trading action to move the share price.

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