News Analysis date published New: 
Friday, January 13, 2012 - 10:00
New Date created: 
Tuesday, January 31, 2012 - 13:35
New Date last updated: 
Friday, January 13, 2012 - 10:00

Now's the Time to Buy Small Caps -- Especially These 2 Stocks

Friday, January 13, 2012 - 10:00am

It sure feels like a challenging investing environment -- especially for smaller stocks, since they are usually seen as the riskiest. But did you know the Russell 2000, a handy proxy for small-cap stocks, has risen a hefty 15% since late November? Then again, the index fell so sharply in August and September, the recent rebound only makes a dent.

Indeed, a broader look at small-cap performance leaves something to be desired: The Russell 2000 Index remains below levels seen five years ago.But there's a real reason for optimism for small caps, as that recent 15% upward move suggests. Small caps perform quite well at the depths of a recession and coming out of it.

In October 1990, for instance, the Russell 2000 stood at 120 as the United States entered into a recession. (That slump led Bill Clinton's campaign strategist James Carville to drum up the slogan "It's the Economy, Stupid.") Well, savvy investors looked beyond that recessionary phase and loaded up small-cap stocks, knowing they would pick up sharply after the slump.

And that's exactly what happened.

By early 1992, the Russell 2000 had rebounded more than 65% to around 200. (It reached new highs throughout the subsequent years as well.)

The recent 15% rebound in the Russell 2000 may be telling us a similar move is afoot.

I looked at the most appealing stocks in that index in the past, but am switching gears to the S&P SmallCap 600, another index that also houses some potentially robust rebounders.

In the table below, you'll find a group of small-cap stocks that are poised to boost sales at least 15% in 2012 and earnings per share (EPS) by a nice 40% -- or more, according to analysts' consensus forecasts. Best of all, these stocks have reasonable downside protection, trading at less than 16 times projected 2012 profits.

With low valuations and robust growth ahead of them, all of these companies are worthy of further research, but I'm especially keen on the prospects of the companies in the oil and gas industry. Gulf Island Fabrication (Nasdaq: GIFI), Pioneer Drilling (NYSE: PDC) and ION Geophysical (NYSE: IO) don't actually produce oil and gas, but provide important goods and services to the drillers and producers.

The combination of high prices for oil and high volume production for natural gas producers means that many potential customers are flush with cash and keen to spend. This helps explain why analysts say each of these companies can sharply boost profits in 2012. Gulf Island Fabrications trades less than 100,000 shares a day, which is too illiquid for my taste, but the other two names surely appeal. Let's take a closer look...

1. Parker Drilling
Last March, I predicted this stock would rise 40% to around $8. Shares have almost hit that target and they still sport a reasonable multiple.
As I noted back then, Parker Drilling rents a wide range of tools used by drillers, from basic hardware all the way up to complex deep-water rigs. The company's rally has been due to the end of the moratorium placed on drilling in the Gulf of Mexico, which was ultimately lifted last summer.

Demand for the company's tools, rigs and other items is rising only slowly, as evidenced by the 4% jump in sales the company is expected register in 2011. But the sales mix has become much more favorable as items like rigs, which carry higher margins, predominate the revenue base. As a result, per-share profits are expected to have risen roughly 500% to roughly $0.50 in 2011. Parker Drilling's results strengthened as the year wore on -- the company blew past profit estimates in each of the last two quarters of 2011, which is why analysts say sales and profits could grow at a fast pace this year.

2. ION Geophysical (NYSE: IO)
This company seems to have gone out of its way to frustrate investors. It holds a solid base of technology and should be growing at a fast clip. Instead, management failed to anticipate slow-to-build demand for its products, so Ion Geophysical boosted sales around 15% in 2011 to $500 million, a growth rate half as big as investors had expected when the year began. The company has missed quarterly expectations three times in a row, and its stock trades for roughly half of its 52-week high.

Ion Geophysical offers a wide range of technologies to customers in the energy-exploration field, from software that maps out subterranean deposits of oil and gas, to services that help clients make the most of that mapping data. Ion saw great demand for its services in the middle of the past decade, when sales rose from $150 million in 2003 to $700 million in 2007. The sharp pullback in energy prices that resulted from the global recession of 2008 quashed demand as clients sought to conserve cash. As a result, sales fell to $444 million by 2010.

Yet with a stock that has been tossed aside, it may be worth tracking what looks like a potential turnaround. Management laid out a roadmap for the company on Dec. 9 (you can read the transcript here).

In this roadmap, management spent a lot of time discussing the oceanographic and land-based seismic analysis trends. (Seismic analysis involves 3-D imaging of surfaces to spot pockets of oil and gas that may be buried deep in land and sea formations.)

As more companies are venturing to Alaska, the ocean bottoms and massive tar sand fields, they need the type of services Ion provides in order to map out a number of important areas in those topographies. The key is to lure a rising number of clients to pay up for already-mapped data or yet-to-be-mapped areas. Ion Geophysical also operates other energy-searching divisions, which I won't go into here, but the entire company appears positioned for an improving 2012 and beyond -- if the company can deliver on some of the opportunities laid out in that early December conference call.

Risks to Consider: Ion Geophysical has delivered several weak quarters in a row, so it pays to see business turn up before buying into this stock. Parker Drilling and Ion Geophysical would see a drop in demand for their products and services if oil prices fall sharply.

Action to Take --> Energy producers are generating ample amounts of cash but are working harder and harder to find new hard-to-tap fields and wells. This sets up a perfect backdrop for these two companies, each of which are expected to see sales and profits rise higher in 2012.

I strongly suggest listening to Ion's fourth-quarter earnings conference call. An inflection point for this business may finally be at hand. Parker Drilling, despite a recent strong run, still trades for less than 10 times profits, making it a good candidate for strong gains.

[Note: If you haven't heard about this unique opportunity, then I want to tell you about it now. StreetAuthority has staked me with $100,000 of real money to invest in my absolute best ideas. For a limited time, you'll be able to follow along with me completely free. Go here to learn more.]

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

The StreetAuthority Insider is a subscriber-only, complimentary publication, exclusively for our paid customers. As a paid subscriber in good standing, you'll now be getting more exclusive access to more investing gurus than ever before. I hope you'll find these periodic missives always informative, occasionally entertaining and consistently helpful to your bottom line.