Holiday season is a great time to find small-cap bargains

We're entering the holiday season, a time of year when bigger is often considered better, whether it be the size of the stack of presents under the Christmas tree, the amount of that end-of-year bonus cheque or the magnitude of this year's New Year's Eve party.

In investing, however, we're approaching a period in which smaller tends to be significantly better than bigger. Historically, smaller stocks outperform their larger peers late in December and early in the New Year, and there are indications that this trend may be in full swing this year.

This phenomenon is believed to be the result of big cyclical trends. One is tax-loss selling, which occurs when investors sell losing positions toward the end of the year to decrease their taxable income, and thus their taxes owed. Smaller stocks are less able to absorb these blows than big stocks are, which can make them particularly susceptible to declines around tax-loss selling season.

In addition, as Mark Hulbert of MarketWatch has noted, mutual fund managers often turn to more conservative, larger stocks toward the end of the year, and dump smaller stocks. They don't want their annual performance numbers to be hurt if bets on smaller issues – which tend to be more volatile – go bad in the short term.

Those factors mean that small-cap stocks often take a hit in early December even if they don't deserve it. They bounce back later in the month and early in the New Year, as investors pounce on the bargains that have emerged.

Last year, the trend didn't play out in Canada or the United States, as small stocks actually underperformed the broader market in late December and the first two months of 2011. But that's not a big surprise. The effect tends to be greater when the market has had a down year, since there are more losing positions that can be sold for tax purposes, Mr. Hulbert notes. And 2010 featured solid gains for stocks.

This year, however, we've had a down year. What's more, small-caps have underperformed: The S&P/TSX Small Cap Index is down almost 20 per cent in 2011 (through Nov. 28), vs. the S&P/TSX composite's 13.4-per-cent loss. Small-caps have also underperformed in the U.S., and on a global basis. With many small-caps well in the red, investors may be ready to jettison them before year-end.

So, in the coming weeks, you should keep a keen eye on the small-cap sector. If investors do start dumping smaller stocks, bargains will be there for the taking. But – and this is critical – don't go snatching up just any small caps. Focus on those that are fundamentally and financially sound. If the historical trend does play out, smaller stocks with strong fundamentals are likely to be the ones investors will be piling into in early 2012. And, if, like last year, the trend doesn't play out, then at least you're adding fundamentally sound stocks to your portfolio.

Here's a handful of small-cap Canadian stocks that my Guru Strategies, each of which is based on the approach of a different investing great, are particularly high on right now.

TransGlobe Energy Corp. : Calgary-based TransGlobe is an oil and gas explorer whose efforts are focused in Egypt and Yemen. Those countries' political turmoil hasn't stopped TransGlobe from growing. Earnings per share jumped more than 150 per cent in the third quarter, and sales nearly doubled.

My Joel Greenblatt-inspired model likes TransGlobe, thanks to its strong earnings yield and return on capital. Those figures make it the ninth-most-attractive stock in the Canadian market, according to this strategy.

Bird Construction Inc. : I wrote about this Toronto-based general contracting firm in my small-cap article last December. It's since changed from an income trust to a corporation, but my Warren Buffett-based model remains high on the company, thanks in part to its 36.7-per-cent 10-year average return on equity – a sign of the "durable competitive advantage" Mr. Buffett seeks in his buys.

North West Company Inc. : This Winnipeg-based retailer of food and everyday products has stores that go back more than 340 years. It operates in Canada, Alaska, the South Pacific and the Caribbean.

North West gets approval from my Peter Lynch-inspired model, which considers it a "slow-grower." Slow-growers are primarily attractive for their dividend yields, and, at 5 per cent, North West's is stellar.

Churchill Corp. : Calgary-based Churchill is a construction and industrial services company. My Lynch-based approach likes the firm's impressive long-term growth rate and 5.7 price-to-earnings ratio, which make for a stellar 0.14 P/E-to-growth ratio.