Here's the trick to exploiting Wall Street's famous January effect

Exploiting the famous January effect on Wall Street isn’t as easy as it looks.

I’m referring to the well-known tendency for stocks of the smallest companies—so-called small caps—to significantly outperform large-cap stocks during January. Since 1926, according to data compiled by University of Chicago professor Eugene Fama and Dartmouth professor Kenneth French, small caps in January have beaten large caps by an annualized average of nearly 30% per year.

No other month is anywhere near as good for small-cap stocks as January. On average across all other months, the small-cap advantage is four percent on an annualized basis.

Yet not all small-cap stocks participate in this seasonal surge. Recent research shows that the small cap stocks that historically have performed the best during January are of companies with the lowest financial quality. These so-called “junk” stocks are very volatile, are from firms that are losing money, pay no dividend, and often are loaded with debt. (This research was conducted by AQR Capital Management, the Connecticut-based institutional money management firm.)

Conventional wisdom says to concentrate on companies that are profitable, for example, as well as having little or no debt and which pay a handsome dividend. Yet the researchers found that January loses any special significance if we focus these so-called “quality” stocks that are at the opposite end of the spectrum from junk.

Why would small-cap junk stocks do so well in January but not the rest of the year? Andrea Frazzini, an AQR principal and an adjunct professor of finance at New York University, said in an email that he and his fellow researchers haven’t explored that question. But he allowed that one possible explanation is that, in January, junk stocks disproportionately benefit from the cessation of year-end tax-loss selling that previously had artificially depressed their prices. That certainly makes sense, since small-cap junk stocks presumably suffer the most in December when investors sell their losers to shield their gains from capital gains taxes.

Regardless of why such stocks do so well in January, there’s little doubt that they are risky. They can soar when and if their business conditions are favorable, yet plunge when the going gets tough. You may very well decide that it isn’t worth the risk. But if you want to give it a try, be sure to invest in a group of such stocks in order to diversify away at least some the higher risk.

To give you an idea of the kind of stocks that you might consider, here are five from the S&P 1500 index that, according to FactSet, have the smallest market caps, have recently been losing money, pay no dividend, and have betas (a measure of risk) that are significantly higher than the overall stock market: Stage Stores (SSI), Tidewater (TDW), QuinStreet (QNST), Northern Oil and Gas (NOG), and Gulf Island Fabrication (GIFI).

If you decide to invest in stocks such as these, be sure to instruct your broker to buy them only if they are at or below a certain price. Such so-called limit orders are especially important for the smallest stocks, since it doesn’t take very many purchases to propel them higher and otherwise force you to pay too high a price.

Mark Hulbert, founder of the Hulbert Financial Digest, has been tracking investment advisers' performances for four decades. For more information, email him at mark@hulbertratings.com or go to www.hulbertratings.com .