The "January Effect" Could Offer Quick Gains for Small-Cap Investors

If your investing tastes run more to small-cap issues than the giants of the Dow Jones Industrial Average and other major indexes, you could find 2010's best buying opportunities before the new year even starts - today (Tuesday) and tomorrow to be precise. That's the promise of the so-called "January Effect," historically one of the most reliable of the recognized stock market anomalies.

Although there are some minor variations, the primary thrust of the January Effect states that stocks do better in January than in any other month - and small stocks do better than large stocks, with the bulk of the gain realized from the final trading day of December through the middle of the following month.

While the first portion of that hypothesis isn't strictly true - historically, April has held a slight edge over January in general stock market performance - the small-stock portion has a strong record. In fact, in some years, small-stock gains in the first trading days of January have accounted for the sector's total advance for the entire year.

According to the book "The Incredible January Effect: The Stock Market's Unsolved Mystery," by Robert A. Haugen and Josef Lakonishok, the performance patterns underlying the Effect were first noticed in the early 1940s. However, its impact wasn't quantified until 1982 when Donald B. Keim, now a professor of finance at the University of Pennsylvania's Wharton School of Business, presented research detailing the January performance disparity dating back to 1925.

Since then, a number of other studies have verified and updated Keim's results. For example, research by the Chicago Board Options Exchange (CBOE) found that, from 1980 through 2006, small-cap stocks as measured by the Russell 2000 Index averaged a return of 2.5% in the month of January. That compared to respective January returns of just 1.7% and 1.6% for the Standard & Poor's 500 Index and the Dow. The largest disparity came in 1992, when the Russell 2000 gained 8.0% versus a 2.0% loss for the S&P 500 and a 1.7% gain for the Dow.

A more extensive study conducted in 2003 by Ibbotson Associates, now a part of Morningstar, Inc. (Nasdaq: MORN), found that, from 1926 through 2002, the smallest 10% of U.S. stocks outperformed the largest 10% of U.S. stocks by an average of 9.35 percentage points during the month of January. It also found that the smallest stocks failed to outperform their biggest brethren in just seven of the 77 years during the period.

Given that level of supporting evidence, the obvious question is: "What causes the January Effect?"

Unfortunately, the answer isn't nearly so obvious.

Some observers have speculated that individual investors often need cash for holiday expenses and sell off small-stock positions to get it, thereby pushing down prices and prompting bargain hunters to rush in and snap up the depressed shares in early January. Others point to the abundance of year-end research reports by brokerages that make small-cap stocks appear particularly attractive to investors looking to rebalance their portfolios in the new year. A third group suggests that the surge in early January buying is the result of corporate employees, sales professionals and other workers investing their Christmas and year-end bonuses.

The most common explanation for the pattern, however, is that individual investors, looking to create losses for tax purposes, sell their weaker positions in the waning days of the year, then spark a January rally by buying them back once the calendar turns. Recently, though, this rationale has been increasingly disputed.

"The notion that tax-loss selling is the basis for the phenomenon sounds logical on the surface, but it's incorrect," says Dr. Eric Kirzner, professor of finance at the Rotman School of Management at the University of Toronto, who has studied market anomalies for more than three decades. "That has been proven by the fact that the January Effect has been found in countries with no securities taxes."

Kirzner believes the best explanation relates to the practice of "window dressing" by mutual fund managers and other institutional investors, who sell off the shares of riskier small companies to make their end-of-year balance sheets look better, then buy them back early in the new year. He also notes that, in years like 2009, when many small stocks enjoyed considerable rallies, taking profits late in the year can boost fund performance figures and thereby increase incentive payouts for managers.

Whatever the reason - a single factor or a combination of the above - you can make money by playing the January Effect by buying small-cap stocks now and looking to take quick gains in mid-January. Be aware, however, that the play's not foolproof.

Like most anomalies - repeating stock-pricing patterns that seem to defy the idea that the markets are efficient - there are blips in the January Effect's record of success. Since 2000, the broader form of the Effect, which has the overall market advancing in January, has proven incorrect six times, in 2001, 2002, 2003, 2005, 2008 and 2009.

Some analysts also argue that greater awareness of the pattern and more attempts to capitalize on it have suppressed the small-stock advantage for all but the smallest of microcap stocks. They point out that small stocks underperformed larger ones in January 1999, 2005 and 2008, and were roughly even in 2002. They also note that a number of the "outperforms" since 2000 came in the form of smaller losses.

Still, it's hard to look at the success rate since 1925 and resist giving it a try, so here are four small stocks you might consider for a quick January run-up. All have good fundamentals so they should stand on their own even if the January Effect falters in 2010, all had decent runs in 2009 and, assuming Dr. Kirzner's fund-related analysis is correct, all have strong institutional support.

  • Beacon Roofing Supply Inc. (Nasdaq: BECN): Based in Peabody, MA, this $756 million company is a wholesale distributor of roofing materials and building products in the United States and Canada. With earnings of $1.15 a share and a price-to-earnings (P/E) ratio of 14.5, Beacon is already ahead in the race to lead a recovery in the housing market. BECN stock is held by more than 150 institutions, with the SmallCap World Fund (5.53%), T. Rowe Price Small-Cap Value Fund (3.61%) and Fidelity Advisor Capital Development Fund (3.06%) holding the largest percentage of shares.
  • FormFactor Inc. (Nasdaq: FORM): Although still operating in the red, this $1.12 billion technology firm has made a strong move from its 2009 lows on predictions that its major customers will be introducing new products that should sharply boost sales in the year ahead. The Livermore, Calif. company, which develops systems to test semiconductor chips and wafers, gets 70% of sales from foreign markets and should have an edge over firms with a heavy domestic focus as the recovery progresses. FormFactor has 139 institutional investors holding nearly 90% of the float, with Buffalo Small Cap Fund (3.31%), Franklin Small-Mid Cap Growth Fund (2.95%) and Fidelity Small-Cap Stock Fund (2.10%) the largest.
  • Global Cash Access Holdings, Inc. (NYSE: GCA) Normally recession resistant, the U.S. gaming industry has been particularly hard hit this time around. In spite of this, Global Cash turned a 40-cent-per-share profit in its last fiscal year, giving it a 19.2 P/E ratio and building a $546 million market cap as casinos continued to shift slot payouts from coins to paper tickets and cashier functions from people to ATMs. The Las Vegas, Nev., company's Casino Cash Plus machines provide gamblers with ATM access to bank accounts and credit-card advances, as well as exchanging slot tickets for cash in a matter of seconds. Global Cash also provides the casinos with information and accounting services related to cash transactions. The company's 141 institutional shareholders include Blackrock Small Cap Growth Equity Portfolio (2.27%), Vanguard Explorer Fund, Inc. (1.23%), and Van Kampen Small Cap Growth Fund (0.85%).
  • National Beverage Corp. (Nasdaq: FIZZ) Non-alcoholic beverages have been one of the most recession resistant in the consumer segment, and National Beverage offers a low-cost way to play to that strength. The Florida-based company manufactures flavored soft drinks, juices, sparkling and nutritionally enhanced waters and energy drinks under the Shasta, Everfresh, Home Juice, Mr. Pure, LaCroix, Crystal Bay and ASante names, among others. The $625 million operation had per-share earnings of 62 cents in its latest fiscal year, giving it a P/E of 22.2. Seventy institutions hold 68% of the stock, with Royce Special Equity Fund (1.23%) and DFA U.S. Micro Cap Series (0.87%) the largest.

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