10 small stocks for a happy new year

By Harry Domash

Editor's note: To view the stock screen mentioned in this column, download the free MSN Money Investment Toolbox.

Often, starting right around now, small-capitalization growth stocks outperform the overall market at least through January and sometimes longer. But this so-called January effect is controversial.

Some say the January effect starts much earlier than it once did and has morphed into a November effect. Others doubt it exists at all. However, academic research supports the notion that small-cap stocks do outperform in January. And given recent market action, I'm sure all would agree that the small-cap stocks' pop has yet to put in an appearance.

The academic research that I mentioned found that the best-performing January-effect stocks were those that had produced losses in the previous year. That seems to make sense if you buy the scenario that tax-loss selling motivates holders to dump their losing stocks in December and buy them back in January.

However, for the past two years, I've attempted to profit from this scenario with uninspiring results. Enough is enough. This year, I'm making a major strategy change.

The concept of buying losing stocks based on the premise that they'll quickly reverse course hasn't worked. I should have known that it wouldn't. What was I thinking? Based on my own experience and the findings of many others, with all else equal, winners keep winning and losers keep losing.

So this year, I'm reversing course and starting with a list of already strong small-cap stocks. Then, from that group, I'll pick the stocks with the best prospects for continuing their winning ways. Further, in response to reader requests, I'm limiting the field to stocks trading below $20. Here are the details of my screen (click here to run it yourself.)

Simply small caps

Market capitalization is a measure of company size. It's calculated by multiplying the recent share price by the number of shares outstanding. Think of it as how much you'd have to pay to buy all of a firm's shares.

Definitions vary, but most experts would agree that stocks with market caps below $1 billion are small caps. For my screen, I set my maximum allowable market cap at that figure. Try increasing the limit to $2 billion if you want to see more stocks.

Screening parameter: Market capitalization <= $1,000,000,000

Stay with the strong

Relative strength, which measures a stock's price performance over a specified time frame compared with the overall market, is the best tool for identifying strong stocks. For example, a relative strength of 70 means that a stock has outperformed 70% of all stocks over the specified period. The screener offers three time frames for relative strength: three, six and 12 months.

I require a minimum relative strength of 50 for six months and for 12 months, which means that passing stocks must have performed at least even with the overall market for those periods. However, I want to see stronger recent price action, so I stepped up the minimum to 75% for the past three months.

Screening parameter: 12-month relative strength >= 50

Screening parameter: Six-month relative strength >= 50

Screening parameter: Three-month relative strength >= 75

Moving on up

Finally, in the price-performance category, to ensure that passing stocks are still in upward trends, I require that qualifying stocks must be trading above their 50-day moving average. A stock's moving average is its average closing price over the specified number of trading days. For instance, the 10-day moving average is the average of the past 10 days' closing prices.

Technicians, those people who pay the most attention to price charts, consider a stock to be in an uptrend when it is trading above its moving average. The 200-day moving average is good for looking at long trends, while the 50-day moving average is best for checking recent price action, which is what I want to verify with this test.

Screening parameter: Last price >= 50-day moving average

The right price

A very low trading price tells you that many market players are avoiding the stock, probably because they see serious problems ahead. In my experience, stocks changing hands below $5 per share are especially risky, so I set my minimum at that level. Don't even think about reducing that minimum.

Screening parameter: Last price >= $5

Many readers tell me that they prefer low-price stocks because they have greater price-appreciation potential. For instance, a $15 stock is a lot more likely to double than, say, Google (GOOG, news, msgs), which the last time I looked was trading around $715. So I set the maximum allowable trading price at $20 per share. Eliminate that requirement if you don't mind seeing more-expensive stocks.

Screening parameter: Last price <= $20

So far, we've isolated small-cap stocks in the desired price range with strong price charts. Next, we'll pick the stocks with the strongest fundamental outlooks from that bunch.

Profitability counts

It doesn't matter whether you're looking for big stocks or little stocks, growth stocks or value stocks -- you'll always improve your odds of success by picking profitable companies over money losers.

Return on equity, which is net income divided by shareholders' equity (also known as book value), is the most widely used profitability gauge. If we were looking for stocks to hold for several months or years, we'd want a minimum 15% return on equity. However, because we're going to hold our January-effect stocks only for a month or so, we care only that the firm is making money, not losing it.

Screening parameter: Return on equity >= 5

Continued: More parameters and the results

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