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The Big Case for Small-Cap Stocks

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The market is "risk-on" and investment strategists are shifting their focus to small-cap stocks, reports CBS News.

"U.S. small-cap stocks are the best long-term investment idea in the entire global equity market this year," says Richard Bernstein, CEO of Richard Bernstein Advisors." A new report from UBS agrees.

The case being made is that while yes, small-cap stock offer higher risk, lower liquidity, and lower market value than large cap stocks, their potential rewards are also more significant.

After a weak performance in 2011 UBS says small caps can offer "superior long-term return potential," adding that given current valuations, "the timing for investment could be fortuitous."

According to CBS News, UBS says small caps have performed better than large caps in the long term (tracked over many decades). There is also more opportunity to add value "since markets are less efficient and small companies have the potential to grow faster." Furthermore, smaller companies are "easier to understand."

Business section: Investing ideas
UBS seems to think small caps have a strong role in the balanced portfolio.

If you're interested in researching small-cap companies for your portfolio, we want to provide you with a starting point.

To find some interesting prospects, we created a universe of small-cap stocks with market caps between $100 and $300 million. To make sure our list is comprised of relatively liquid stocks, we took the top 150 with the greatest trading volume.

We then screened these stocks with high ratios of levered free cash flow/enterprise value (LFCF/EV).

Levered free cash flow is the free cash flow after deducting interest payments on outstanding debt. Enterprise value is the sum of the firm's value from all ownership sources: market cap, outstanding debt, and preferred shares.

Companies with high ratios of levered free cash flow/enterprise value may be undervalued by the market.

So, do you think these small-cap companies should be trading higher? (Click here to access free, interactive tools to analyze these ideas.)

1. Gentiva Health Services: Provides home health services and hospice care in the United States. Market cap at $226.54. Levered free cash flow at $112.85M vs. enterprise value at $1.04B (implies a LFCF/EV ratio at 10.85%).

2. Willbros Group (NYSE: WG  ) : Provides engineering, procurement, and construction services to the oil and gas, refinery, petrochemical, and power industries primarily in the United States, Canada, and Oman. Market cap at $226.24. Levered free cash flow at $64.11M vs. enterprise value at $472.28M (implies a LFCF/EV ratio at 13.57%).

3. Obagi Medical Product: Develops and markets topical aesthetic and therapeutic prescription skin care systems. Market cap at $207.02. Levered free cash flow at $25.13M vs. enterprise value at $185.62M (implies a LFCF/EV ratio at 13.54%).

4. Anadigics (Nasdaq: ANAD  ) : Provides semiconductor solutions to the broadband wireless and wireline communications markets. Market cap at $202.46. Levered free cash flow at $15.28M vs. enterprise value at $140.96M (implies a LFCF/EV ratio at 10.84%).

5. FuelCell Energy (Nasdaq: FCEL  ) : Engages in the development, manufacturing, and sale of high temperature fuel cells for clean electric power generation primarily in South Korea, the United States, Germany, Canada, and Japan. Market cap at $168.78. Levered free cash flow at $14.57M vs. enterprise value at $134.95M (implies a LFCF/EV ratio at 10.8%).

6. Excel Maritime Carriers (NYSE: EXM  ) : Provides sea borne dry bulk cargo transportation services worldwide. Market cap at $160.9. Levered free cash flow at $291.38M vs. enterprise value at $1.18B (implies a LFCF/EV ratio at 24.69%).

7. Majesco Entertainment (Nasdaq: COOL  ) : Provides interactive entertainment products primarily in the United States and Europe. Market cap at $107.87. Levered free cash flow at $14.35M vs. enterprise value at $96.28M (implies a LFCF/EV ratio at 14.9%).

Interactive Chart: Press Play to compare changes in analyst ratings over the last two years for the stocks mentioned above. Analyst ratings sourced from Zacks Investment Research.

Kapitall's Rebecca Lipman does not own any of the shares mentioned above. Data sourced from Yahoo! Finance

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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