The small and micro cap stock rally in early 2012 has caught a lot of people off guard. Many smaller companies with relatively poor fundamentals, such as negative earnings and low return on equity (ROE), blasted higher right out of the gate and the rally has lasted longer than I believe many investors expected.
This includes a lot of companies that underperformed in 2011.
For example, small cap sectors such as materials, technology and energy are up 10%, 7% and 4%, respectively, through January 18. This is a sharp recovery after those sectors were down between 4% and 10% in 2011. Individual names have moved much more to the upside.
Meanwhile, some higher quality names – those with positive EPS and higher ROE – are flat or even falling.
In retrospect it's not too surprising that investors were ready to add a little more risk to their portfolios early in 2012, especially when the perceived lower quality small and micro cap stocks were pretty beaten down.
This trend has been great for micro cap investors who held through the gyrations of late 2011 and have recently enjoyed double-digit gains. A lot of these stocks are relatively unknown because their fundamentals don't leap off the page on a typical fundamental-based stock screen.
I expect the strong recent performance of many of these small and micro cap stocks has raised investor awareness and they'll be on more buy lists as we get further into the first quarter. For those who have held these names through the rally, this may provide an opportunity to lock in some profits.