Start Small, Win Big

Wall Street pros have nothing on retail investors who stake small sums of money monthly on undervalued small-cap stocks. Because they're mostly ignored by the big guns, these types of stocks offer the best outsized opportunities for growth.

Below, we screen for stocks with less than $3 billion in market cap, offering earnings surprises of 15% or more in the previous quarter, with long-term earnings growth forecast to be at least 15%. We'll then filter our findings through the collective investing wisdom of the Motley Fool CAPS community and those they think have the best chance for winning.

Here are some of the stocks this simple screen found:

Company

Market Cap

EPS Actual vs. Estimate

Average Analyst 5-Year EPS Estimate

CAPS Rating (out of 5)

Questcor Pharmaceuticals (Nasdaq: QCOR  ) $2.9 billion 17% 38% ***
Skullcandy (Nasdaq: SKUL  ) $393 million 25% 22% **

Sources: Yahoo.com and Motley Fool CAPS.

Of course, this is not a list of stocks to buy -- just a starting point for more research. We need to look more closely at these companies to see whether analysts' faith in them is well-founded.

Testing new highs
Is this going to be a recurring theme for Questcor Pharmaceuticals, seeing exponential growth in sales of multiple sclerosis treatment Acthar? There was a time when everyone was doubtful Acthar would amount to much because of fears over changes to Medicaid and Medicare reimbursement policies. Since then, however, Questcor has put those fears to rest. Last quarter, it tripled the number of paid prescriptions; this quarter, those more than doubled while profits tripled. It shipped 4,111 vials of Acthar in the first quarter alone.

The risk here, however, is not just from competing treatments like Pfizer's (NYSE: PFE  ) MS therapy Solu-Medrol or Lundbeck's Sabril for infantile spasms, but really because Acthar is Questcor's only product on the market (sales of its insomnia treatment Doral are negligible). Any problems in manufacture, distribution, or competition -- a new, better rival can always appear -- and the impact to the biotech would be severe. Without any patent protection as well (the patents on Acthar have expired), someone could start producing a knockoff, especially as it seems the treatment is particularly successful.

So with shares of Questcor up 122% over the past year, I find there's risk embedded in the stock, though at 13 times earnings estimates and looking at its growth prospects, it seems it has a little more room to run yet. CAPS member Dallen510 doesn't think it's peaked yet:

Look for continued explosive growth, especially from NS treatments which saw Q1 sales that almost topped sales from the entire 2011 year. Estimated market sizes for each drug are $1 billion annually, which makes current market share around 17% and growing for each. Additionally, the company is researching new uses for the drug.

Tell me on the Questcor Pharmaceuticals CAPS page if you see exponential growth continuing, then add the stock to your watchlist to see if it can continue to pump news sales into its channels.

Developing a hankering for growth
I'll admit to thinking Skullcandy is more sizzle and little substance, sort of the Kim Kardashian of headphones. Its flashy audio gear seems to have little to support a long-term growth thesis, as there is no moat to defend its product from rivals -- and it has plenty of them. Dr. Dre's Beats, for example, certainly has enough name recognition and cachet when it comes to headgear to pose a legitimate threat.

Yet despite having all the lasting satisfaction of cotton candy, Skullcandy saw sales surge 48% this past quarter generating a 5% jump in earnings, handily surpassing analyst expectations. The stock is also heavily shorted (and I stress heavily), so the drop in value that it's experiencing after the earnings report might not be all that unexpected.

But I can't escape the lack of moat and the fickle nature of consumer tastes; Skullcandy, in my opinion, is a fad doomed for the graveyard. Of course, it could always be a takeover target for Sony (NYSE: SNE  ) , JVC, or Bose, which may want the fashion style associated with the skull icon, but I don't find that a compelling way to invest. Hoping someone buys your company before it crashes and burns is hardly a successful strategy.

I've rated the accessories maker to underperform the broad market averages on CAPS, but add Skullcandy to the Fool's free portfolio tracker and tell me in the comments section below if you think its headgear is worthy eye candy.

Foolish final thoughts

These companies may have the odds stacked against them, but the Motley Fool has identified two stocks that are also facing difficult times yet still grow revenues hand over fist. The report is free, but it's only available for a short time, so ask for your copy today and find out the two cash kings that are changing the face of their industry.

Fool contributor Rich Duprey owns shares of Pfizer, but he holds no other position in any company mentioned. Click here to see his holdings and a short bio. The Motley Fool owns shares of Skullcandy and Sony. The Fool has created a bear call spread position in Sony. Motley Fool newsletter services have recommended buying shares of Pfizer. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (2) | Recommend This Article (1)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 07, 2012, at 3:24 PM, tcp1130 wrote:

    Scullcandy is not a fad

  • Report this Comment On May 07, 2012, at 9:31 PM, BuiltByNoah wrote:

    Agreed. Not a fad. Yes Beats by Dre has serious props. But Skullcandy is going to be much more than headphones. Already jumped into iPhone cases. Next iPad. Then backpacks. Then ball caps. Then clothing. It's the beginning of an evolution. Who ever said it stopped at earbuds? That's a waste of the next best trademark.

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