Best of 2012: Small Caps

After a down 2011, small cap stocks rallied in a big way in 2012.

The Russell 2000 index, which gauges the performance of U.S. small caps, returned 16% last year – a marked improvement from the 5.7% drop-off the index suffered in 2011. It was the index’s best performance since 2009.

As always, some small caps stood out more than others. Here were three of the best performing small cap stocks of 2012 – two of which share a common thread:

• Arena Pharmaceuticals (NASDAQ: ARNA): With a mind-boggling 382% gains, Arena was the king of all small caps in 2012. Producers of a weight-control management drug, this California-based biotech company is cashing on America’s growing obesity epidemic. The company reported record revenue in the second quarter, but has struggled to turn a profit. However, the promise of its obesity drug attracted scores of investors. Until the company proves it can turn a profit, though, it will be difficult for Arena to repeat its epic 2012 run this year.

• Infinity Pharmaceuticals (NASDAQ: INFI): Noticing a trend yet? Infinity was another biotech pharmaceutical company with better than 350% gains last year. Unlike Arena, however, Infinity turned a profit in the third quarter, and could have a tad more staying power.

• Hovnarian Enterprises (NYSE: HOV): Up 350% last year, Hovnarian Enterprises is a homebuilder that rode the wave of last year’s housing recovery. Like with Arena, however, Hovnarian’s rise had more to do with overly optimistic investor sentiment than true value. As of October 31, Hovnarian had a negative shareholder equity of $485 million, wasn’t profitable last quarter, and has future earnings estimates of only about 47 cents a share. Hovnarian’s 2012 performance was impressive. But housing recovery or no housing recovery, don’t expect an encore in 2013.