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InvestorEducation / Learning to Invest Jul 23, 2008 - 05:36 AM GMT

By: Money_and_Markets

InvestorEducation

Best Financial Markets Analysis ArticleNilus Mattive writes: I love scouring the market for attractive stocks with smaller market capitalizations (the number of shares outstanding times the current stock price), especially ones that pay nice dividends.

That's because smaller stocks tend to have better growth prospects. After all, it's easier to post big gains when you're starting from a smaller baseline. Most investors recognize this simple concept.


But, when it comes to smaller stocks, there's another interesting little possibility that a lot of investors miss, and it can instantly boost a smaller firm's share price. I'm talking about ...

The Index Kicker: Small Stocks Gain When They Are Added to Market Gauges

In and of themselves, indexes are simply lists of stocks that are carefully assembled to represent the general performance of a particular market. For example, the S&P 500 contains 500 of America's largest and most respected companies.

When a company gets added to an index, it's a sign that the firm has achieved a certain status in the minds of some important market watchers. But nowadays, it can be a big deal in another way. Let me explain ...

A movement has slowly been gaining momentum — instead of just using indexes as a measure of their own portfolio's performance, many investors are now investing in products that try to exactly match a benchmark's performance.

The approach is called passive investing, and it started with a whole new category of investments — index funds (in both the mutual and exchange-traded varieties). Here's how these investments work ...

Instead of trying to pick a basket of individual stocks that will outperform a target index, the funds' managers try to pick the basket of stocks that will best match the index's performance. The managers won't always buy every single stock in the index, but they'll generally buy at least most of them. Since not as much research goes into this endeavor, index funds will typically charge lower fees than actively-managed funds.

Vanguard Group was the first shop to launch an index fund for retail investors — the Vanguard 500 Index Fund — way back in 1976. But in the last decade or so, the trend has really caught on. Vanguard's fund now has about $190 billion tied to it! And there are plenty of other similar investment vehicles. In fact, an estimated $1.3 trillion is currently in portfolios directly tied just to the S&P 500 index.

I won't quibble with the popularity of index funds — for investors seeking a simple approach to investing, these vehicles are a real boon.

But they can also help those of us who still try to beat the market, especially when we're already holding a stock before it gets added to a major index ...

When a stock gets added to a big index, a lot of funds are forced to buy it.
When a stock gets added to a big index, a lot of funds are forced to buy it.

Remember, many passive managers will buy the stock once it goes into their target benchmark. The resulting stampede can result in a nice pop in the stock's price. That's especially true in the case of additions to the S&P 500 since so much money is tied to the index.

This happened to a company in the Dividend Superstars portfolio a while back. Shortly after the stock was recommended, it was selected for the "500." The shares gained as much as 10% the week of the announcement.

Now, that instant kicker doesn't always last forever, but even so, getting added to a major index is also just plain ol' good publicity for a smaller stock. The resulting headlines can be enough to get a bunch of new investors interested in the shares ... and that's always a welcome development.

Unfortunately, there's no sure-fire way to know what stock is going to go into a major index next. But there are things you can watch out for.

For example: S&P's major U.S. indexes only include companies that are headquartered in the U.S. Generally, they must have at least four quarters of consistent profits, too. So you can quickly start narrowing your list down based on these kinds of criteria.

Moreover, each index has capitalization requirements. So if you see a company that is currently in the S&P MidCap 400, and its market value is bumping up against the upper range of that index's limit — currently $5.5 billion — it might be a good candidate for the "Major League" S&P 500 at some point down the line.

There's no hard-and-fast rule — a firm doesn't automatically leave an index even if it's outgrown the parameters. But knowing these ranges can help you in your search.

I look at it this way: Worst case, doing some of this digging will turn up a few smaller, profitable firms that you might not have heard about before. And that's precisely what makes researching investments fun and profitable.

Best wishes,

Nilus

P.S. Want to know more about my favorite smaller dividend-paying stocks? Subscribe to Dividend Superstars for just $39 and you'll get 12 monthly issues chock full of great income stocks.

This investment news is brought to you by Money and Markets . Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com .

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