You'd Be Stupid to Buy These Stocks

"You'd be a dope to snap up shares of companies like Stone Energy (NYSE: SGY), American Axle & Manufacturing Holdings (NYSE: AXL), Century Aluminum (Nasdaq: CENX), and Sunrise Senior Living (NYSE: SRZ) -- all of which are up more than 500% since March's market low." 

That's what you might be hearing, now that the small-cap Russell
2000 Index is outpacing the S&P 500 by 10 percentage points. Even The Wall Street Journal predicts that the small-cap rally is set to come to a screeching halt. 

But don't be duped ...
Just because many
small-cap stocks have experienced a huge increase in the past few
months doesn't mean you should avoid all of them.

First, no one accurately called the market's bottom in March, so
it's dubious whether anyone has the ability to call a top just a few
months later.

Second, the Russell 2000's sharp rise has largely been driven by the speculative bidding-up of penny stocks
(stocks with share prices below $5). Many companies whose share prices
exceeded $5 in March have not shared in the astronomically high returns
-- including companies whose fundamentals have actually improved year to date.

This trend isn't unique to small caps. In fact, S&P 500 stocks
whose prices fell below $5 during this bear market -- including Bank of America (NYSE: BAC), E*TRADE Financial (Nasdaq: ETFC), and Advanced Micro Devices (NYSE: AMD) -- have been some of the highest gainers in that index, with each up more than 100% since the bottom.

But this still raises the question: Why have penny stocks risen quicker than non-penny stocks?

Pain, baby, pain

Behavioral
psychologists refer to the "pain of paying" -- the mental barrier we
face when parting with our cash. The higher the cost, the higher the
barrier.

For investors focusing on share price (instead of, say, underlying
company quality), it's less painful to toss an extra dime per share
into purchasing a penny stock -- even if that dime represents twice
what the stock was trading for the day before -- than it is to toss in
an extra $5 per share for a stock that was trading for more than $100 a
share the day before.

Rational? Certainly not.

However, this speculative irrationality presents the savvy small-cap investor with a great opportunity.

How to cash in on small-cap movement
There are two ways you can profit from the rush to penny stocks:

1. Join the rush, and wager your hard-earned money by guessing which penny stock might rise next.

2. Invest in small-cap companies whose fundamentals have been improving, but which are still undervalued by the market.

As much as we'd all love to have a stock shoot up nearly 4,500% in just a few months -- as penny-stock micro-cap Diedrich Coffee recently did -- at the end of the day, the first tactic is nothing but a risky crapshoot.

So though your inclination might be to go for the gusto to make up
for losses, the second option is really the only way to set yourself up
with a portfolio that will grow your wealth at above-average rates over
long periods of time.

After all, the best small caps have the ability to consistently outperform -- which is why they have consistently been the top-performing stocks of the past four years.

Time to be smart
One company I think you'd be smart to buy right now -- one that I have my eye on, and which the team at Motley Fool Hidden Gems recently purchased shares of -- is Brink's Home Security.

Brink's has a market cap of just $1.4 billion, and it boasts a clean
balance sheet, with $103 million in cash and zero debt. Best of all,
it's trading for less than eight times the Hidden Gems team's calculation of steady-state cash flow.[a4] 

The stock has risen significantly since the end of 2008 -- but the
team still expects market-beating returns over the next two to three
years, with very little risk. 

You can browse through the team's whole investment thesis, and
examine the in-depth valuation of this company and many others,
completely free with a trial membership to Hidden Gems. Click here for more information.

© 2009 UCLICK L.L.C.