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 the big guns mostly ignore them, these types of stocks offer the best, outsized opportunities for growth.

We'll screen for stocks under $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 two stocks this simple screen found:

Company

Market Cap

EPS Actual vs. Estimated

Average Analyst 5-Year EPS Estimate

CAPS Rating (out of 5)

Manitowoc (NYSE: MTW  ) $1.7 billion 28% 15% ****
Merge Healthcare (Nasdaq: MRGE  ) $297 million 300% 20% ****

Sources: Zacks, 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.

Back in a flash!
Heavy-equipment makers are doing the heavy lifting in the economy as Caterpillar (NYSE: CAT  ) , Terex (NYSE: TEX  ) , and Manitowoc all reported strong sales in the second quarter, with the construction industry providing a surprise lift.

Caterpillar enjoyed an 8% increase in sales in its biggest segment, as did Terex, which said the construction segment returned to profitability for the first time since 2008. Manitowoc's cranes were also in high demand, with revenues rising more than 10%, even though currency exchange rates affected results by $32 million.

The weak global economy has hurt performance of the machinery and construction industries, but North America has been a rare exception. Where once it was China that was looked to in order to keep everyone's engines running, it's facing a sharp slowdown that may very well send a new chill across the industry.

That could work to Manitowoc's benefit as it derives the bulk of its revenues here in the United States. In 2011, domestic sales accounted for 44% of the total. Caterpillar realized 38% of its sales from North America last quarter, while Terex saw just 28% from here. Yet all three carry relatively the same market multiple based on estimated earnings, though when you factor in analyst growth estimates, Cat does look most ready to pounce.

Still, analysts could be short-changing Manitowoc here, and its domestic focus could help it surpass its rivals. I've rated the crane maker to outperform the market averages on CAPS, even though its food-service business has been relatively flat, but you can tell me in the comments box below if you agree it will be getting more lift in the future.

A graven image
According to analysts at Zacks, the market researchers at Frost & Sullivan estimate the digital doctor's office is currently a growing $7.5 billion market, given a further push high by both passage of Obamacare and the president's trillion-dollar stimulus program several years ago. Imaging software and services, health-care IT coordination solutions, and electronic medical records across various disciplines posit favorable demographic changes offering sustained demand.

The analysts think Merge Healthcare ought to snare a good portion of the funds flowing to the sector, because investments in health-care IT will increase as professionals and hospitals are herded toward adopting greater electronic health-record solutions. General Electric (NYSE: GE  ) and McKesson will undoubtedly get their share as two of the biggest players in the space, but Merge is expected to hold its own.

Merge generates revenue primarily from software sales and the hardware behind it, as well as professional services and various electronic data services. Where it used to record most of those sales as perpetual license agreements, it changed its revenue recognition model earlier this year to a subscription-based one that matches how its customers make purchases. It's looking for the benefits of this change to really kick in in the back half of the year, and it's notable the stability in its performance despite slowing spending on equipment and technology as economic uncertainty permeates the landscape.

Medical imaging is only going to become a bigger component in the health-care field, so I'm rating Merge to outperform the broad indexes on CAPS, but you can let me know in the comments box below if you see it improving its image and bottom line with the new revenue model.

A small price to pay
Caterpillar is always going to be economically sensitive, but that doesn't mean it's not a good investment. But is now the right time to buy? Get some valuable insight on the machinery giant from the Fool's premium research report on Caterpillar, in which our top analysts look at the company's challenges and opportunities going forward. Learn more.

Fool contributor Rich Duprey owns shares of General Electric, but he holds no other position in any company mentioned. Check out his holdings and a short bio. Motley Fool newsletter services have recommended buying shares of McKesson. We Fools don't 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. The Motley Fool has a disclosure policy.


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