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Small caps that may reap the benefits of the 'January Effect' Add to ...

While fundamentals drive stock returns over the long haul, other factors can push stocks higher or lower in the short term.

Economic cycles, political events, even weather patterns - all of these and more can have a temporary effect. In most cases, however, these forces are extremely hard to predict.

But there are some broader market patterns that have proven to be quite reliable over the long term. As we move into December, we're entering the sweet spot for one of them: the "January Effect." This refers to the habit of small-capitalization stocks to significantly 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.

There's logic behind the January Effect. For one thing, toward the end of the year, investors start selling losing positions for tax reasons. While larger stocks can better absorb the impact of such selling, smaller stocks often get hit hard in November and early December, making them candidates for a rebound.

Mutual fund managers also appear to get more conservative toward the year's end and focus on larger stocks, 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.

While it doesn't occur every year, the January Effect has a solid long-term track record. Mark Hulbert of MarketWatch has called it "one of the strongest historical patterns that researchers have ever documented in the stock market."

Still, I don't recommend making it the cornerstone of your investment approach. If you are going to tilt toward small caps around this time of year, you should make sure you're focusing on strong, financially healthy companies with reasonably priced shares.

With that in mind, I went looking for some of the most fundamentally sound small caps in the Canadian market using my Guru Strategies stock screens. Each of these screens is based on the approach of a different great investor.

Here are some of the best small caps I found (defining a small cap stock as one with less than $2-billion in market capitalization). Keep in mind that smaller stocks like these tend to be more volatile than larger stocks.

Home Capital This Toronto-based financial firm is the parent of Home Trust Company, which offers deposit, mortgage lending, retail credit and credit card issuing services.

Home Capital gets strong interest from my Peter Lynch-based model. One big reason is its PEG ratio (that is, its price/earnings ratio divided by the long-term growth rate of its earnings per share). This ratio stands at just 0.38. The Lynch model considers anything below 0.5 to be a sign that the stock is a big-time bargain.

Home Capital is also one of the few firms to pass my Lynch-based "net cash position" bonus criterion. Its net cash/price ratio is an impressive 41.1 per cent. (Net cash is the sum of cash and marketable securities minus long-term debt.) That's a sign that the firm is in good financial position.

Rona Quebec-based Rona is Canada's largest distributor and retailer of hardware, renovation and gardening products, operating a network of almost 700 stores.

Rona wins approval from my Benjamin Graham-based model. Known as the father of value investing, Mr. Graham used a very conservative approach. This strategy likes Rona's 2.58 current ratio; the fact that its long-term debt is less than the value of its net current assets; and its share price - the stock trades for just 0.89 times book value and 11.6 times trailing 12-month earnings.

Bonterra This Calgary-based oil and gas company was formerly an income trust, but converted back to a corporation in the fall of 2008. It gets strong interest from the strategy I base on the writings of hedge fund guru Joel Greenblatt.

In his Little Book that Beats the Market, Mr. Greenblatt unveiled a remarkably simple market-beating strategy that looks only at two variables: earnings yield and return on capital. With an earnings yield of 11.6 per cent and a return on capital of more than 56 per cent, Bonterra is the 19th-most-attractive stock in the Canadian market, according to my Greenblatt-inspired approach.

Bird Construction This Toronto-based general contractor isn't just a solid small cap - it's actually the highest-rated stock in the entire Canadian market, according to my models, getting approval from my strategies based on Peter Lynch, Warren Buffett, Joel Greenblatt and Kenneth Fisher.

The Lynch approach likes Bird's stellar 0.29 PEG ratio, and its lack of any long-term debt. My Buffett-based model likes the firm's strong history of earnings growth and its 37.7-per-cent average return on equity over the past decade.

The Greenblatt-inspired approach, meanwhile, likes Bird's 42-per-cent return on capital and its earnings yield of 22.7 per cent, while the Fisher-based strategy likes Bird's 0.56 price/sales ratio and $4.44 in free cash per share.

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