We've all heard it said that small caps are inherently risky investments, and there's some truth to that, but don't overplay it.

The case for small caps
Long-term academic research suggests small caps outperform large caps, and when you include small caps in a portfolio, it serves to increase returns of the total portfolio. What's more, there is a lower correlation between small caps and large caps that can actually lower your total risk.

"That small caps are risky is, to me, an urban legend," said Ken Farsalas, Director of US Equities and Co-Portfolio Manager of the Oberweis Small-Cap Opportunities Fund. "There were far more risky blue chip stocks in 2008 than small cap stocks in the same year. Maybe 90% of investors would have told you AIG and Citi were less risky than Chipotle and lululemon at that time -- they would be wrong."

As for the market, Farsalas is optimistic. "When people start losing money in bond funds they're going to flip flop hundreds of billions of dollars into equities over the next 2-3 years, providing more fuel for the bull market run."

Turn to the pros
Oberweis Small-Cap Opportunities Fund specializes in building competitive portfolios made up of companies with market caps between $250 million and $3 billion. "We look at small-cap companies with a bottom-up approach, and our expectations differ from consensus expectations," Farsalas told Kapitall. "We look for companies with a sustainable and competitive position, and potential for upward revisions in the future."

He believes the tech industry, while cyclical in the short term, is a good place to start because all the "next-big-things" are coming from this market.

"The next biggest thing is sure to be ubiquitous conductivity," continues Farsalas. This is when a single device controls everything from your email to your refrigerator, as exemplified by the iPhone and iPad. Video on demand will also see heavier demand.

Company specific
Farsalas discussed three companies that show promise of big gains:

First, The Fresh Market (Nasdaq: TFM), something like a mini-Whole Foods that serves regional pockets and is trying to go national. Its business model reflects Whole Foods' in its early years, and the company plays on the nation's increasing desire to eat more natural and organic foods. The recent "pink slime" controversy can't hurt either.

Second, Select Comfort (Nasdaq: SCSS), which is one of Oberweis's top holdings. The company makes the sleep number beds and was near bankruptcy not too long ago. But by closing underperforming stores, paying off debts and improving its balance sheet, and refocusing its market strategy, the small firm has come a long way, already growing 164.8% in the last year.

"The improving housing market and employment numbers should bolster sales because more people are feeling better about their financial situation." The Street puts forward earnings at $1.30/share, but Oberweis expects $1.45/share.

Lastly, Farsalas is excited about Acacia Research Corporation (Nasdaq: ACTG). This company licenses and enforces patented technologies and it is the clear leader in its field. It has acquired rights to over 200 patent portfolios, including those related to 3G and 4G networks, wireless video streaming, and semiconductor techs.

"Because of scale, tech companies are going straight to them ... Acacia has signed very large comprehensive patent license for big companies like Oracle and Microsoft and others may be coming in the future that we think will include Apple, Google and HTC." The Street puts ACTG's forward earnings at $1.80/share, but Oberweis expects $2.50/share.

Business section: Investing ideas
Looking for other small-cap winners? Here is a list of small-cap companies (market cap between $250 million and $3 billion) that have consistently 'surprised' analyst earnings estimates over the last four quarters. Do you think that these stocks will continue to outperform?

Below that, we created another list of small-cap companies. This time we screened for net insider buying in the past six months, institutional buying in the current quarter, and short covering month-over-month. Three groups of sophisticated investors feel bullish about these four companies. Do you agree with their optimism?

(Click here to access free, interactive tools to analyze these ideas.)

1. Carter's: Designs, sources, and markets branded children's wear. Market cap of $2.93B. In March 2011: Reported EPS at 0.55 vs. estimate at 0.5 (surprise of 10%). In June 2011: Reported EPS at 0.23 vs. estimate at 0.13 (surprise of 76.9%). In Sept. 2011: Reported EPS at 0.67 vs. estimate at 0.59 (surprise of 13.6%). In Dec. 2011: Reported 0.63 vs. estimate at 0.44 (surprise of 43.2%. [Average earnings surprise at 35.92%]. The stock has gained 73.84% over the last year

2. World Fuel Services (NYSE: INT): Engages in the marketing and sale of marine, aviation, and land fuel products and related services worldwide. Market cap of $2.92B. In March 2011: Reported EPS at 0.58 vs. estimate at 0.54 (surprise of 7.4%). In June 2011: Reported EPS at 0.7 vs. estimate at 0.58 (surprise of 20.7%). In Sept. 2011: Reported EPS at 0.74 vs. estimate at 0.66 (surprise of 12.1%). In Dec. 2011: Reported 0.7 vs. estimate at 0.69 (surprise of 1.4%. [Average earnings surprise at 10.4%]. The stock has gained 1.36% over the last year

3. Signature Bank: Provides business and personal banking products and services in the New York metropolitan area. Market cap of $2.90B. In March 2011: Reported EPS at 0.82 vs. estimate at 0.72 (surprise of 13.9%). In June 2011: Reported EPS at 0.87 vs. estimate at 0.78 (surprise of 11.5%). In Sept. 2011: Reported EPS at 0.83 vs. estimate at 0.8 (surprise of 3.7%). In Dec. 2011: Reported 0.85 vs. estimate at 0.84 (surprise of 1.2%. [Average earnings surprise at 7.58%]. The stock has gained 11.77% over the last year.

Here's a list of small-caps with net insider buying in the past six months, institutional buying in the current quarter, and short covering month-over-month.

1. Susser Holdings: Operates convenience stores and distributes motor fuels in Texas, New Mexico, Oklahoma, and Louisiana. Net insider shares purchased over the last six months at 51.50K, which is 0.36% of the company's 14.40M share float. Net institutional purchases in the current quarter at 3.3M shares, which represents about 22.92% of the company's float of 14.40M shares. Diluted TTM earnings per share at 2.68, and a MRQ book value per share value at 16.23, implies a Graham Number fair value = sqrt(22.5*2.68*16.23) = $31.28. Based on the stock's price at $25.68, this implies a potential upside of 21.82% from current levels.

2. NL Industries: Operates in the component products industry in the United States, Canada, and Taiwan. Net insider shares purchased over the last six months at 112.17K, which is 1.71% of the company's 6.55M share float. Net institutional purchases in the current quarter at 377.4K shares, which represents about 5.76% of the company's float of 6.55M shares. Diluted TTM earnings per share at 1.68, and a MRQ book value per share value at 8.53, implies a Graham Number fair value = sqrt(22.5*1.68*8.53) = $17.96. Based on the stock's price at $14.79, this implies a potential upside of 21.41% from current levels.

3. Kraton Performance Polymers (NYSE: KRA): Through its subsidiary, Kraton Polymers LLC, produces styrenic block copolymers (SBC) for use in industrial and consumer applications worldwide. Net insider shares purchased over the last six months at 957.10K, which is 3.51% of the company's 27.23M share float. Net institutional purchases in the current quarter at 949.6K shares, which represents about 3.49% of the company's float of 27.23M shares. Diluted TTM earnings per share at 2.81, and a MRQ book value per share value at 16.14, implies a Graham Number fair value = sqrt(22.5*2.81*16.14) = $31.94. Based on the stock's price at $27.23, this implies a potential upside of 17.31% from current levels.

4. Cumulus Media: Engages in the acquisition, operation, and development of commercial radio stations in the United States. Net insider shares purchased over the last six months at 8.55M, which is 14.88% of the company's 57.46M share float. Net institutional purchases in the current quarter at 10.5M shares, which represents about 18.27% of the company's float of 57.46M shares. Diluted TTM earnings per share at 0.46, and a MRQ book value per share value at 1.94, implies a Graham Number fair value = sqrt(22.5*0.46*1.94) = $4.48. Based on the stock's price at $3.62, this implies a potential upside of 23.78% from current levels.

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. Institutional data sourced from Fidelity, short data, EPS, BVPS and insider data from Yahoo! Finance.