How to Find Great Small Caps

Tom Gardner receives dozens of questions each week about his Hidden Gems investing philosophy, one that is soundly beating the market. Fellow Gems team member Rex Moore recently pulled together the most common questions for an interview with Tom.

This is the first of a five-part series. All other parts are linked to the right of the page.

Rex Moore: Would you briefly describe for us your investing framework at the highest level? What do you look for in the small-cap stocks you select in Hidden Gems?

Tom Gardner:I start most of my small-cap research by looking at valuations. Over any two to three month period, I sort through hundreds of different companies, looking at two things first: (a) the company's ability to generate cash, and (b) what the market is paying for that cash.

Of course, there are promising small cap companies that aren't yet cash-flow positive. But my focus is on those small businesses that have already emerged into profitability and are unlikely to fall back into negative territory. I'm looking for companies that generate more cash than is needed to run the business, which they can put toward debt reduction, share buybacks, dividends, or focused acquisitions.

From there, I look at company growth rates one by one. How fast are cash flows expanding? And are the historic growth rates steady or lumpy? Has there been a change in the product mix? As I sort through operations, I apply Michael Porter's principles of competitive strategy, asking: "What exactly is the durable competitive advantage here?"

Finally as I go through businesses, I don't demand familiarity with their products upfront. I gladly research businesses of which I'm not yet a customer. Sure, it's beneficial to be, but not necessary. And as I go, I begin to encounter businesses like Fresh Del Monte (NYSE:FDP). I'd been eating and loved its new Gold Pineapple. Hadn't considered it as an investment. And I'd seen in stores but not yet purchased home entertainment furniture from Hooker Furniture (NASDAQ:HOFT). And I was familiar with Select Comfort (NASDAQ:SCSS) mattresses, researched the business, then went out and bought one.

Whether I know the product going in or not, my first goal is to find small-cap companies that are profitable, generating free cash flow, and priced at attractive multiples relative to their growth rates.

From there, my focus turns to the management team: who they are, how long they've been in place, how they are compensated, and how much of the business they own.

Rex: Investors are encouraged to look at stocks from the perspective of a value or a growth investor. When I think of small caps, I think of finding the next Microsoft (NASDAQ:MSFT). Are you more of a value or a growth investor?

Tom: There are various ways to label the investments that I make in Hidden Gems. They aren't all the same. I'm not always aspiring to find the next Microsoft, back in 1986, newly public, ready for a dozen years of extraordinary growth. In fact, some of my best investments have been basic turnarounds. In those cases, I'm placing a John Neff-like bet on the company's ability to emerge from a difficult period, a period during which its stock got hammered. New management has arrived or the company now has a narrower focus on one product or service, having abandoned the jack-of-all-trades approach.

Sometimes these turnarounds end up being beautiful two-year investments after which there are few prospects for superior growth rates. Then it's time to move on. That's more of a value investment for me.

With growth investments, I have slightly different goals. With an example like Possis Medical (NASDAQ:POSS), which I've recommended in Stock Advisor, I'm looking for a business that's a leader in an important industry, that has a durable competitive advantage, and that has superior growth rates. Possis Medical is a leader in medical technology, with a device that can extract clots very quickly. It has a wonderful corporate mission, and it can reasonably be expected to grow in excess of 20% or 25% a year. The stock is up 65% for me over the past year, and I think the business value could double from here over the next three to four years.

A lot of value investors shy away from fast-growth companies like this. They point out that with just one bump in the road, the share price will collapse. But in the case of very well-run companies, I accept that. If you can find truly solid businesses at attractive initial prices -- and I think Possis Medical is a fine example -- then the high, sustained growth rate can compound much higher valuations for you.

If you read closely through the work of Peter Lynch, you'll note that he truly loved companies that were growing the top line in excess of 20%. He felt you could find some major multibagger investments there, if you could find and hold that superior growth for five to 10 years.

So, I balance the two. I mix in value investments, classic turnarounds. That takes a willingness to row your way into troubled waters, looking for companies that are struggling to get back to shore. If they succeed, the investment returns can be extraordinary. And if you find the rare turnaround that then morphs into a growth story, that's where you find the 10- to 50-baggers.

But you can also find great long-term investments just by tracking down well-run small businesses growing the top line above 20%. If they're undiscovered by Wall Street as of yet, with few analysts following them and low institutional ownership, the standout small-cap growth stories (like Microsoft nearly 20 years ago) can deliver astounding super-long-term returns.

Tomorrow: How to keep the proper perspective on losers and winners.

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Tom Gardner owns shares of Microsoft. The Fool has a disclosure policy.