This Stock Yields 9.7% and Offers 40%-Plus Upside

With the exception of energy, 2014 was a good year for nearly all of the major market sectors. Healthcare, utilities, technology, consumer staples and other groups have all logged healthy double-digit gains. But when you examine performance by market capitalization rather than by sector, a different story unfolds.

While the blue-chip heavy S&P 500 ended the year up 14.7%, smaller stocks have gone almost nowhere. The benchmark Russell 2000 Index limped to a 4.9% return, with hundreds of its components either flat or underwater for the year.

[ad#Google Adsense 336×280-IA]That’s a bit perplexing for two reasons.

First, smaller companies (as compared with globetrotting multinationals) are more closely leveraged to the U.S. economy, which has been among the world’s strongest.

Second, smaller companies are less exposed to the surging U.S. dollar, which is sitting near multi-year highs versus other foreign currencies and thus a major handicap for manufacturers trying to sell their goods overseas.

All things equal, these factors would give small-cap stocks an edge.

But in the financial world, things are rarely equal. And as you can see from the chart below, there was a sharp dichotomy in performance last year.

So why did smaller companies lag last year? Well, the biggest reason is that they needed a breather. In 2013, the Russell 2000 sprinted to a massive 37% gain, one of its biggest runs in many years. By and large, the underlying earnings of these companies couldn’t keep pace and valuations became stretched — so money rotated out of small caps and into larger companies.

This scenario has played out time and again over the past few decades across all asset classes. One year mid-cap growth is in favor, the next it’s out of style and investors become enamored with something else. You can see the phenomenon clearly on Callan’s periodic table of asset classes.

My main takeaway from this chart (which I’ve been observing since the late 1990s) is that chasing whatever is hot is usually a recipe for mediocrity. If anything, you’re better off putting your money in whatever hasn’t been working the past year or two.

Last year’s laggards often become this year’s leaders and vice versa.

I bring this up because it may happen again with small-caps. This time, smaller companies have been generating impressive earnings growth, yet the shares haven’t responded at all.

So 2015 is shaping up to be the exact opposite of 2014. In fact, the Russell 2000’s year-to-date return of 3.8% is already besting the S&P 500’s 2.6%.

Money has a way of finding relative value, so small-caps are likely to regain their momentum this year. With that in mind, I went out in search of a few prospects to help you gain exposure to this sector. Each has a market cap between $200 million and $2 billion and above-average yields between 4% and 10%.

CaptureAccording to a study by Barclay’s bank, small-cap stocks would have turned a $1,000 investment in 1926 into more than $14 million today, versus $2 million for larger stocks.

It stands to reason that these smaller companies, which are still typically in the earlier stages of their development and growing more rapidly, would generate superior gains over the long-haul. Conventional wisdom says that small caps don’t pay dividends — but that’s clearly not the case; some are quite generous.

Don’t expect to see a turnaround just because the calendar flipped from 2014 to 2015. But I do think investor sentiment for this group is improving. One indicator I would watch for here is contracting junk bond spreads — a reliable signal that the economy is gaining steam and a big positive for small caps.

On the list above, I recently recommended Calumet Specialty Products (Nasdaq: CLMT), as my “High-Yield Security of the Month” in the September 2014 issue of High-Yield Investing. Distributions have been climbing briskly for this leading maker of specialty petroleum products, but the shares have been pulled lower by falling oil prices (even though crude is a feedstock).

This disconnect will get straightened out eventually, leading to potential gains of 40% or more — on top of the hefty dividend yield. This pullback has put CLMT near the top of my watch list.

— Nathan Slaughter

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Source: Street Authority