By Louis Basense, contributing editor The Oxford Club

It's not secret that small caps perform best coming out of recessions. Further, if we want to ride the small-cap rally for maximum gains, we should similarly rotate into small-cap value stocks.

Thankfully, it’s an easy transition to make. I say that because the most attractive small-cap value investment is sitting right under our noses. No one on Earth is better at discovering small-cap value investments than David Dreman.

In fact, over the last five years, he’s beaten the small-cap value index handily, by an average of 7% per year. (He’s outperformed the index over the last decade, too.) 

History clearly dictates a rotation into higher quality, undervalued small caps as this bull market progresses. However, this go-round could mark the most pronounced rotation ever. I say that because I expect private equity shops – flush with $1 trillion in cash – to return with a vengeance. 

After all, mergers and acquisitions (M&A) activity always picks up coming out of recessions, too. And financing no longer exists for the mega-billion dollar deals. So it stands to reason that the next M&A boom will be fueled by an abundance of smaller deals. 

Dreman's long-term outperformance is no accident. He pays great attention to the stock-filtering process. He insists on companies with market caps between $300 million and $2.5 billion, trading at a discount to the market and industry price-to-earnings ratio, with low leverage, low price-to-book and price-to-cash flow ratios, strong management teams and a catalyst that could spur future growth.

Or, more plainly put, he does much more than look for companies that investors have discarded. He unearths the most undervalued, highest quality companies. Such a systematic approach and impressive track record is precisely why we added his Dreman Contrarian Small Cap Value Fund (DRSVX) to our All-Star Portfolio last summer.

We’re already sitting on a 28% return, thanks to the sweeping rally in small-cap stocks. But with the rotation into value stocks imminent – and a small-cap rally well underway – the returns should kick into overdrive in the year ahead. 

Remember, the fund allows us to buy 95 to 100 of the most compelling small-cap value stocks in the market. And if you believe in buying low and selling high, this is your opportunity. The average stock in the fund trades for a price-to-earnings ratio of 11 – a whopping 81% discount to the average stock in the S&P 500. 

Clearly, plenty of upside remains as these stocks play catch-up with the rest of the market. If you haven’t purchased the Dreman fund yet, do so before it’s too late. If you already own it, consider doubling down. This time next year I’m confident you’ll be glad you did. 

History clearly dictates a rotation into higher quality, undervalued small caps as this bull market progresses. However, this go-round could mark the most pronounced rotation ever. I say that because I expect private equity shops – flush with $1 trillion in cash – to return with a vengeance. 

After all, mergers and acquisitions (M&A) activity always picks up coming out of recessions, too. And financing no longer exists for the mega-billion dollar deals. So it stands to reason that the next M&A boom will be fueled by an abundance of smaller deals. That bodes well for the individual holdings in the Dreman fund, and in turn our profitability, as they could be acquired. 

Learn more about this financial newsletter at The Oxford Club.