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2 Top Small-Cap Stocks to Buy in October

By Timothy Green – Oct 13, 2016 at 6:00AM

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Stocks that few people have on their radar often represent the best opportunities.

Image Source: Getty Images.

Small-cap stocks, those with market capitalizations less than $2 billion, get far less attention than larger companies. The spotlight rarely shines on companies that are large enough to matter, but small enough to escape the interest of most investors.

It's exactly this lack of interest that creates opportunities for investors willing to do some digging. Here are two small-cap stocks that investors should consider this month.

A beaten-down sandwich stock

Image Source: Potbelly.

Shares of sandwich shop chain Potbelly (PBPB 2.46%) have not fared well since the company went public in late 2013. The stock price has been more than cut in half from its peak, with investors coming to the conclusion that the growth story simply isn't compelling enough to justify a nosebleed valuation.

But investors shouldn't confuse the performance of the stock and the performance of the company. Potbelly is doing just fine, growing comparable sales, expanding its base of restaurants, and generating impressive restaurant-level margins. During the second quarter, comparable sales rose 1.7%, a slow pace of growth to be sure, but growth nonetheless.

At the end of the second quarter, Potbelly operated 382 stores, with another 39 locations franchised. The company plans to open a total of 40-45 company-operated restaurants this year, and there's no reason why a quick rate of restaurant-count growth can't continue for years to come. The opportunity with any small restaurant chain comes from the chance that it someday becomes a large restaurant chain.

Overall, Potbelly is profitable, with the company expecting to produce between $0.36 and $0.38 in per-share adjusted earnings this year. That puts the PE ratio in the stratosphere, but profitability has the potential to improve dramatically as the company grows. The restaurant-level profit margin was 21.2% during the second quarter, and that number has been improving. As the store count grows, the companywide operating margin should grow, as well.

With Potbelly stock trading for just about 0.8 times analyst estimates for 2016 sales, investors will be rewarded handsomely as long as the company continues to profitably grow. That's not a guarantee, as many restaurant chains hit a wall well before they reach their full potential. Potbelly doesn't need to be the next Chipotle to deliver solid results for investors, but it does need to keep growing for the foreseeable future.

A cash-rich semiconductor equipment stock

Image Source: Kulicke & Soffa.

I've recommended buying shares of Kulicke & Soffa (KLIC 0.57%) on multiple occasions over the past year, and I'm doing it again today. The stock is up about 10% year to date, but I think there's still an opportunity for significant gains.

Kulicke & Soffa sells semiconductor packaging equipment. The company dominates the wire-bonding portion of the market, and it also competes in the advanced packaging market thanks to its acquisition of Assembleon in late 2014. Because the semiconductor equipment market is cyclical, Kulicke & Soffa's revenue and profits tend to fluctuate. But over the past decade, the company has only produced a net loss once -- during the depths of the financial crisis. Net income has averaged $65 million annually over the past 10 years.

With a market capitalization of just $900 million, the company has a current PE ratio of about 19.7. That may not seem all that cheap, but Kulicke & Soffa is also sitting on a boatload of cash. At the end of the latest quarter, the company had $516 million in cash and essentially no debt on the balance sheet. Valued fully and backed out, the stock's cash-adjusted PE ratio falls to just six.

Unfortunately, much of this cash is held overseas, which means it can't be used for share buybacks or dividends without paying taxes to bring it back into the country. The stock is incredibly cheap, in part because the market isn't giving the company much credit for its mountain of cash, and it's unclear when that situation will change.

Despite these issues, Kulicke & Soffa is an underappreciated small-cap stock with a fortress balance sheet and a long record of profitability. For value-focused investors, it's worth a look in October.

Timothy Green owns shares of Kulicke and Soffa Industries. The Motley Fool has no position in any of the stocks mentioned. 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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