Small Stocks --- The Best Stocks to Buy in This Cold Market

You're probably getting all sorts of conflicting messages these days.

On the one hand, you have gloom-and-doom predictions from luminary economists like Nouriel "Dr. Doom" Roubini, calling an S&P 500 bottom possibly as low as 600 -- more than 20% below yesterday's close.

On the other hand, you have the world's most respected investor, Warren Buffett, saying that now is a good time to buy. Buffett is also putting new money to work, buying shares of Burlington Northern (NYSE: BNI) and Ingersoll-Rand.
Here, with so much debate over what has been roundly dubbed "the worst financial crisis since the Great Depression," we looked back at how various strategies fared during each of the other financial crises since the Great Depression, and try to get some useful guide to go through this economy depression.

To get started, I turned to trusty data from Ibbotson Associates, a leading authority on investment research. I calculated the historical returns for cash, bonds, and stocks for those who invested the year following the start of each recession -- exactly the point at which we find ourselves today -- and measured the five-year annualized return for each period.

Here are the results:

*Data from Ibbotson Associates, Salomon Brothers Long-Term High-Grade Index, National Bureau of Economic Research, Consumer Price Index, author's calculations.
**Returns calculated from 1971-1975.

Rule your recession
Three lessons stand out from this data:

Stocks outperform bonds and T-Bills most of the time, and by large amounts. And remember, these are just averages -- stronger index components like PepsiCo (NYSE: PEP) and Procter & Gamble (NYSE: PG) did even better than the S&P 500 average the last time around.

Unless you need money or plan on investing it, don't park your capital in cash or Treasury bills. If you're bearish enough on stocks to avoid the stock market, history shows that it's much better to be in a diversified batch of long-term, high-grade corporate bonds.

The only period the S&P 500 lost money was the 1930-1934 deflationary death spiral, when deflation ran a chilling 5% annually. Inflation currently sits around 0.4% annually, but so long as it doesn't plunge well below zero and remain there -- something even Roubini, the most prominent stag-deflation advocate, doubts will happen -- investors who are looking to buy a diversified basket of stocks today are well-positioned.

But that's not the whole story
Various studies -- including one of my own -- show that small caps tend to outperform their larger counterparts by a significant margin, particularly in recessions. To confirm this, I ran the numbers once more to include the smallest quintile of stocks:*Data from Ibbotson Associates, Salomon Brothers Long-Term High-Grade Index, National Bureau of Economic Research, author's calculations.
**Returns calculated from 1971-1975.

Small stocks outperformed T-Bills, bonds, and the S&P about two-thirds of the time -- and they did so by a ridiculous margin.

But how much dough are we talking about?
A few percentage points might not seem like much, but remember, these are annualized figures. Here's how much money $1,000 invested and held for each five-year period would be worth today, adjusted for inflation:
The data over 13 recessionary periods and various academic studies reveals a powerful lesson: Small stocks really are the best stocks to consider buying in this market.

Why are small stocks so great?
There are many reasons for why all of the market's best stocks have been small caps. Among the three most prominent are:

Small caps attract less coverage from major brokerage houses and consequently are more likely to be mispriced.

Smaller stocks have more opportunities for growth.

Smaller companies have the ability to be nimbler in tricky situations. Starbucks (Nasdaq: SBUX) has been handling the complex logistics of closing 8% of its more than 7,000 U.S. stores. On the other hand, if tiny Buffalo Wild Wings had to close 8% of its 575 stores and reallocate resources, it could do so relatively easily.

These may also explain why all of the top 30 performers that emerged from the 2001 recession were small or mid caps, including USG, (NYSE: USG), Coach (NYSE: COH), and Research In Motion (Nasdaq: RIMM), which each rose more than 700%.

Source from: fool.com

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