This from Investment U:

Forget the grim news that Alcoa (NYSE:AA) is slashing costs and cutting 13% of its workforce. We all know times are tough. But the market’s a forward-looking beast. And right now, it’s doing exactly what I predicted on November 19. It’s favoring small caps over large caps.

In December the little guys put up big numbers – a 5.8% gain versus a mere 1.1% uptick for the large guys, based on the Russell 2000 and S&P 500 indexes.

Before I get to my favorite ways to screen and play this emerging small-cap rally, let me first address my critics.

My last column failed to convince some of you. Others thought I simply skimped on the proof. Or more specifically, that I failed to tell you why NOW is the right time to buy small caps.

As they put it, “We all know small caps lead the markets out of a recession. But what makes you so convinced we’re on the way out?”

As my college physics professor liked to say before each lecture, “Prepare to be enlightened.”

Why It’s Prime for Small-Cap Investing

Let me first disclose, I’m not a market timer. I don’t look for single infallible data points to signal my buys or sells. Instead I track trends (both long and short term). And there’s no denying the trend at the National Bureau of Economic Research – the committee responsible for officially uttering the economic curse word, recession.

You see, these guys – albeit a collection of the most educated and intelligent economists – have a knack for being late. By the time they make the call, the recession is usually close to over. Or in the case of the last two recessions (1990 and 2001), over completely.

This time will be no exception. The government’s about to dope up the economy on stimulus packages. In other words, plenty of economic growth is in the works. If you’re skeptical spending massive amounts of money we don’t have will do the trick, I understand. But just realize, something will prove to be the catalyst for a turnaround. And the numbers belie that something will materialize very soon:

• Since 1900, the average recession lasted 14.4 months.
• And since World War II, only two recessions (1973 and 1981) lasted longer than 15 months.
• So strictly by the numbers – based on a start date of December 2007 for the current recession – odds are this recession will be history by early spring.

You could argue, if you dare utter the words that “this time will be different,” that we’ve never experienced such a financial collapse. And the averages could be meaningless.

Fair enough. But again, I challenge you to recall any other period when so much stimulus (in the form of obscenely low interest rates, tax breaks and massive government spending) poured into the markets with no impact.

It doesn’t exist.

Ultimately, we’re at the tail end of this recession. And we know that means a small-cap rally is next. If you really want to press your luck, you could wait to until the end of the first quarter to consider small caps stocks. But I wouldn’t.

Being late could mean missing out on serious profits. Whenever you decide to jump in, here’s how I would go about finding the best opportunities…

Small-Cap Investing: The Big 3 Screening Criteria

In this market, our primary concern needs to be credit. Companies need it to operate and grow. Small caps are no exception.

That’s why the first thing I screen for is small companies with no or little debt (debt-to-equity ratios below 0.3). This alone will narrow down your choices significantly. But it will also reduce your risk.

Next, screen for companies with a sustainable competitive advantage. It could be revolutionary products, an insurmountable first-mover advantage, or extremely high barriers to entry. Anything that protects the underlying business from competition and enables the company to do the most important thing of all – increase earnings by at least 30%.

Yes, such companies do exist. And a market panic can only hold them back so long. Eventually, share prices will follow earnings. If you stick to the fastest-growing companies, I guarantee you’ll be holding onto the fastest-growing stocks, too.

Beyond these criteria, look for companies within three years of an initial public offering. Wall Street tends to overlook many of these firms. Plus, smaller and/or newer companies have more room to grow.

2 Small Caps Stock Investments to Bank On

In November, I singled out Genoptix, Inc. (Nasdaq:GXDX) and American Pubic Education, Inc. (Nasdaq:APEI). I still consider both strong buys. I’d also add these two small caps to the list:

E-House Holdings (NYSE:EJ).

Debt-to-equity checks in at 0.07. It could easily be zero as the company has enough cash to pay off debt almost six times over. E-House possesses an insurmountable first-mover advantage in the real estate agency services industry, with 1,800 professionals in offices in more than 20 cities. And its earnings have increased 62%.

I know. It’s a real-estate stock. And a Chinese stock, to boot. But that doesn’t matter. Nothing’s going to put a stop to the Chinese wealth creation machine. And the next big ticket item (after a television, refrigerator, air conditioning and a car) for the Chinese middle class is a home. If you have any doubt, consider E-House increased sales 63% in the first nine months of 2008. Despite such impressive fundamentals, shares trade for just 15 times forward earnings. But they’re on the move, up 51% since December 1, 2008.

American CareSource Holdings, Inc. (Nasdaq:ANCI)

Debt-to-equity checks in at zero. ANCI has just $16,000 in outstanding debt and over $8 million in cash. The company’s competitive advantage comes from its size and position as the first ancillary benefits management company. ANCI helps companies control health care costs by offering cost effective alternatives to physician and hospital-based services through its network of 2,400 providers. It also uses a proprietary software platform to help clients identify additional areas for cost improvement. Growth is off the charts with revenues up 127% and earnings quadrupling in the most recent quarter.

It goes without saying that controlling health care costs is a big concern. For the government and individual business owners alike. As a result, demand for ANCI’s services will only increase. And just because you probably never heard of the ancillary health care market, don’t think it’s small. At $574 billion it accounts for 30% of total national health expenditures. Given the current fascination with cutting costs, that percentage will only increase, leaving endless opportunities to grow for ANCI.

Source: Small-Cap Investing: How to Play The Emerging Small-Cap Rally

This from Investment U:

It’s not official yet. Apparently the committee of “esteemed” economists at the National Bureau of Economic Research (NBER) doesn’t get paid for timeliness. But the statistics don’t lie… we’re in a recession.

And that’s got me giddier than an Obama supporter scoring an inauguration ticket. That’s right. I’m actually glad the economic data stinks. Because when a recession is here, a small-cap rally isn’t far behind.

Accordingly, I’m loading up on small caps in my own portfolio. I suggest you do the same, instead of joining the lemmings piling into Treasuries.

If you’re reluctant and afraid small caps are too risky, chew on this:

In the year following the six major bear markets of the last century, small cap stocks soared an average of 82%, according to Ibbotson Associates.

If the prospect of an 82% gain doesn’t excite you in these trying markets, check your pulse. If it does, read on…

Any Old Small Cap Just Won’t Do

There’s no denying the strong historical trend, but it doesn’t mean ALL small caps will soar. Nothing in investing is ever that easy. In order to really benefit from the imminent rally, we need to isolate the most compelling and innovative small-cap stocks.

To that end, let me share a disciplined approach that’s always served me well. When it comes to small caps, I focus exclusively on companies with these three characteristics:

• A pioneer on the verge of creating new trends. Companies can create products to compete in existing markets… Or they can create products that are so revolutionary and timely that they launch their own markets and trends. The latter obviously positions the company, and in turn investors, to reap the most profits. If you need help qualifying this factor think Intuitive Surgical (Nasdaq: ISRG), Google (Nasdaq: GOOG), even VMware (NYSE: VMW).

• Within three years of an initial public offering (or major index listing). Smaller and/or newer companies have more room to grow. Plus, Wall Street tends to overlook many of these firms. By focusing on these young and virgin opportunities, we can actually profit ahead of the Wall Street institutions and the trillions in capital they control.
• Increasing earnings by at least 30%. A market panic can only hold back fast growing stocks for so long. Eventually, share prices will follow earnings. By focusing on companies with the strongest growth profiles, we set ourselves up for the most dramatic gains. And yes, even in this market such companies do exist.

Other characteristics worth screening for include: recurring revenue streams, potential applications for products in parallel markets, new products in the pipeline, little or no analyst coverage and management ownership of 10% or more.

Granted, the process of actually finding such companies is tedious and time consuming. But as Abraham Lincoln quipped, “Things [profits] may come to those who wait, but only the things [profits] left by those who hustle.”

In other words, all the hard work we put into indentifying these small-cap stocks will be rewarded. But if we don’t grab the profits while we can, another investor will.

Short on Time? Buy These 2 Small Caps… And Call Me in a Year

I recognize not all of us can scour the markets each day in search of the most compelling opportunities. So let me make it easy for you. Here are two small-cap companies I’m convinced will be 50% higher (or more) a year from now. [Editor's Note: To get all of Lou's small-cap recommendations, you can sign up here.]

• Genoptix, Inc. (Nasdaq: GXDX) The economic cycle doesn’t impact business for this provider of bone marrow and blood-based cancer tests one bit. Sadly, when it comes to diagnosing cancer, people can’t wait for better times. But the company’s focus on community-based oncologists also provides ample growth opportunities. Earnings increased 198% in the last nine months to $26 million. And yet, the company still only controls 4% of the market.
• American Public Education, Inc. (Nasdaq: APEI) This West Virginia-based company provides online, post-secondary education to a very specific market – military personnel. Its niche focus is delivering impressive growth, with revenues and earnings up 56% and 72%, respectively, in the most recent quarter.

Whether you opt for these recommendations or seek out your own, it doesn’t matter. A recession is here, so a small-cap rally isn’t far behind. Before it’s too late, I recommend you position yourself accordingly.

Source: Small Caps: It’s Time to Think Small