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Don’t fear the January Effect – profit from it Add to ...

John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the Omega Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.

The January Effect: The name has the ring of a Tom Clancy spy novel, the type in which a covert agent races through city streets, trying to thwart a nefarious plot to unleash chaos on the world – and profit from it.

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The truth, however, is that the January Effect is far more real, far less nefarious, and markedly less clandestine – and it’s something you can profit from.

I’m talking about the phenomenon in which small stocks tend to outperform their larger peers in the weeks leading up to the end of the year, and in the first several weeks of the new year.

Usually, when a market trend becomes known, its effectiveness vanishes. But history shows the January Effect has been pretty robust over the long-term.

Why is that? Toward the end of the year, tax-loss selling usually ramps up (that’s when investors sell losing positions, decreasing their taxable income for the year). While larger stocks can better absorb the impact of such selling, smaller stocks often get hit harder in November and early December, making them prime for a rebound.

In addition, mutual fund managers often get more conservative and focus on larger stocks as the year comes to a close, not wanting to take on smaller stocks that can be riskier in the short term.

Toward the end of December, however, tax-loss selling abates, and when January rolls around, fund managers start to get more aggressive. Investors who sold stocks for tax purposes at the end of the previous year often put that money back to work. The result: Small-caps usually reap the benefits.

MarketWatch’s Mark Hulbert points to data from professors Eugene Fama and Kenneth French that show the smallest 10 per cent of stocks averaged a 7.9 per cent return in January from 1926 through 2011, versus an average of 0.9 per cent in the other 11 months. Larger stocks showed no such anomaly.

Of course, that doesn’t mean you should dive headlong into small stocks. The January Effect does not occur every year. And if you are going to tilt your portfolio toward smaller stocks, you would be wise to focus on fundamentally sound, quality plays.

Back on Dec. 9, 2010, I wrote a column about the January Effect and offered four small stocks that my fundamental-focused Guru Strategies (each of which is based on the approach of a different investing great) liked.

On average, they returned 8.9 per cent from Dec. 9 through the end of January, 2011, while the S&P/TSX Composite returned 2.9 per cent.

Today, I wanted to use a Motley Fool-inspired strategy, based on the writings of co-creators Tom and David Gardner, to find some small-caps that are looking good. The Fool-based strategy targets smaller, under-the-radar stocks with strong growth, good momentum and conservative financing.

Among its criteria: Sales and earnings per share should have grown at least 25 per cent in the most recent quarter from a year earlier, relative strength should be at least 90 over the past year, and the long-term debt/equity ratio should be no higher than 5 per cent. While the strategy wants to see strong growth and momentum, it’s not willing to pay bloated prices for them – a stock’s P/E-to-growth (PEG) ratio should be below 0.5.

The Fool-based strategy has been an exceptional performer. A 10-stock U.S. portfolio picked using the strategy has produced annualized returns of 16.6 per cent since its July 2003 inception versus just 5.7 per cent for the S&P 500. That ranks first among all my Guru Strategies. The Canadian version of the portfolio, meanwhile, has returned 13.7 per cent since its August 2010 inception, compared to 3.4 per cent for the S&P/TSX Composite.

The strategy is a rigorous one, looking at 16 variables in all. It’s rare to find a stock that passes all of them, but those scoring in the 70 per cent to 80 per cent range often fare quite well. Here’s a look at some such stocks right now.

Marlin Business Services (MRLN)

This New Jersey-based firm provides equipment financing services for small and mid-sized businesses. It gets a solid 76 per cent score from my Fool model. A few reasons: It has 18 per cent profit margins, it grew earnings per share (EPS) at a 57 per cent clip last quarter, and it has a PEG ratio of just 0.34.

Friday close: $23.00 (U.S.), down 30¢

Enghouse Systems Limited (ESL)

This Ontario-based small-cap provides enterprise software solutions used in a variety of markets and industries, ranging from customer service to energy to transportation. It gets an 84 per cent score from my Fool model. It grew earnings at a 41 per cent clip and sales at a 31 per cent clip last quarter, has a 91 relative strength and has no long-term debt.Friday close: $28.69 (Canadian), down 18¢

Center Bancorp, Inc. (CNBC)

Another New Jersey-based financial, Center is the parent company of Union Center National Bank, a full-service banking company with a 90-year history. Center gets an 83 per cent score from my Fool-based model. The strategy likes Center’s high and growing profit margins, its strong cash flow per share and its bargain-priced PEG of 0.38.

Friday close: $17.93 (U.S.), down 3¢

Alliance Fiber Optic Products Inc. (AFOP)

Alliance makes high performance fibre-optic components and integrated modules for the optical network equipment market. The California-based firm gets a 76 per cent score from my Fool-based model, which likes its 200 per cent increase in EPS and 86 per cent advance in sales last quarter. It also likes that Alliance has a 92 relative strength and a very attractive 0.36 PEG ratio.

Friday close: $13.73 (U.S.), down 16¢

Disclosure: I own shares in Alliance Fiber.

 
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