When I think about the process of finding good, small companies, I'm often reminded of a commonsensical and undeniably logical comment once made by famed investor Warren Buffett. If you are a basketball coach walking down a busy street in search of potential players for your team, what kind of attributes would you look for? You might look for a number of things -- jumping ability, quickness, and hand-eye coordination among them. But the most obvious thing to keep an eye out for, according to Mr. Buffett, would be any seven-foot-tall kids who might happen to saunter by.

In a lot of ways, Mr. Buffett's fictitious basketball-coach-on-the-street example is similar to the plight of the small company investor. Both the coach and the small-company investor have a number of potential options in front of them in terms of selecting new members for their teams. There may be dozens of prospective basketball players on a busy street, just as there are literally thousands of publicly traded small companies floating around in the stock market. The trick is in figuring out how to narrow down the field somehow.

One of the keys to the Foolish 8 screening system for small cap stocks is that it approaches this selection problem from two very different angles. It includes setting both business-specific requirements and market-specific hurdles. All told, half of the Foolish 8 screens have to do with fundamental business attributes, while three others primarily consider market-related measures. A final screen falls somewhere in the middle.

The four business-level screens set minimum standards for the following things:

  • earnings and sales growth (at least 25% in both cases)
  • net profit margins (at least 7%)
  • operating cash flow (a positive figure)
  • insider holdings (at least 10% ownership)
Basically, these four requirements help separate the seven-footers from the five-footers. It's nothing personal against the five-footers out there -- they may in fact be decent businesses in their own right. But if the goal is to generate consistently high returns from a portfolio of good small companies, it makes sense to seek out the firms that have a few fundamental business advantages right from the start.

In contrast, the next three Foolish 8 requirements are not focused on finding the attributes that go into making a good small business. Rather, to carry on the earlier analogy, the object of these screens is to simply narrow the number of streets that Mr. Buffett's imaginary basketball coach needs to travel down.

Sure, the longer a coach walks around town and the more side streets he strolls down, the more likely he is to find seven-footers. However, it is also reasonable to expect that a smart coach may try to save some time by limiting his search to the areas where these human skyscrapers might congregate. This might mean concentrating on the streets with the most schoolyard basketball courts, or even the avenues with the largest concentration of big-and-tall clothing shops.

In the same vein, three out of the four remaining Foolish 8 screens are intended to highlight stock market neighborhoods where good small companies are likely to hang out, based mostly on stock-related attributes:
  • stocks with $1 million - $25 million in daily dollar volume
  • stocks with $7 minimum share prices
  • stocks with relative strength ratings of 90 or higher
The common thread uniting these three requirements is that they are largely out of a company's hands. They are all functions of the whims of the market to a certain extent, and may not be related to any business-related factors at all.

The final Foolish 8 screen sets a $500 million limit on a firm's annual sales, which might be viewed as primarily a business attribute. However, it differs from the four previously mentioned business-related screens in at least one important way. Unlike the first four screens, it is a ceiling rather than a floor. In other words, it is not so much a method for separating the seven-footers from the five-footers as it is a means of limiting the entire potential basketball player universe.

On the other hand, revenues are not determined by the market, so this final screen doesn't fit the mold of the three market-specific Foolish 8 screens either. The $500 million sales hurdle is unique from all of the other screens due to the definitional role it plays in deciding what is and what isn't a small company, at least in our Foolish eyes. 

Despite their specific differences, all of the Foolish 8 screens do share one key element in common -- they are designed to help the investor identify the seven-footers of the small company world. Unfortunately, the ultimate stock selection process isn't nearly as easy as walking down the street and picking out the folks who are quite literally heads and shoulders above the rest. It's important to keep in mind that the Foolish 8 screens are a starting point and not the ending point of sound stock analysis. But by using a combination of business-related and market-related screens from the outset, investors using the Foolish 8 system will be well on their way toward fielding their own team of good small company winners. 

Small Companies, Not Small Caps »