4 Small-Cap Stock Ideas

Let's start things off with a little quiz. While many of us know the stock market has averaged about 10% annual returns over the years, when was the last time it actually returned 10%... or anywhere close to it?

The answer: 1993, when the S&P 500 rose 7.1%.

Since then, the index has been crazy, returning -1.5%, 34%, 20%, 31%, 26.5%, 19.5%, -10%, -13%, -23%, and 26%. When it comes to the market, there's really no such thing as a "normal" year.

Here's how 2004 has behaved thus far:

Data provided by Barra

Rather dull by comparison to the last several years, eh?

Small is exciting
If you've had trouble finding interesting stock ideas in the current stagnant market, you're not alone. We've all read that some of the world's top investors, such as Warren Buffett, are sitting on piles of cash because there just aren't many bargains presenting themselves out there.

For this reason -- and many more -- it makes sense to go hunting for smaller companies. Buffett and other large investors can't touch small caps because they can't buy enough shares to make any meaningful difference to their overall investment returns. That's good news for us, because fewer investors in the small-cap arena mean fewer geniuses, fewer bids in a given week or month, and more pricing inefficiencies.

So would you like to find good small-cap ideas? Good! Here's a little gift for you -- the complete Foolish 8 list as of Oct. 15. Many of you are familiar with the Foolish 8. Originally developed by David Gardner and published in the first edition of The Motley Fool Investment Guide, it attempts to identify profitable, rapid-growth, small-cap stocks, using the following eight criteria:

1. Revenues: $500 million or less
2. Earnings and sales growth: 25% or greater
3. Net profit margin: 7% or greater
4. Daily dollar volume: $1 million to $25 million
5. Insider holdings: 10% or greater
6. Share price: $7 or greater
7. Relative strength: 90 or greater
8. Operating cash flow: a positive number

It has performed admirably over the years according to the American Association of Individual Investors (AAII). This well-respected, not-for-profit company tracks various screens and, according to its data, the Foolish 8 has produced a 266% cumulative return from December 1997 (when it started tracking screen results) through last month. The S&P 500, by comparison, returned 15% in the same time frame.

(The Modified Foolish 8, which I developed several months ago, returned 397% during that period, according to AAII's backtested returns. That screen is featured each month only in Hidden Gems.)

With 19 companies passing the screen, the list is rather long this month. Which of these might turn out to be a wonderful success story such as Home Depot (NYSE:HD) (up 22 times in value since 1990), Amgen (NASDAQ:AMGN) (up 70 times), or Dell (NASDAQ:DELL) (up 700 times)? I honestly can't say which, if any, will. But here are four I think are worth further research.

1. Deckers Outdoor (NASDAQ:DECK) offers outdoor and casual footwear to retailers, including the Teva, Ugg, and Simple brands. It has increased sales about 25% per year since a reorganization in 2001, and should grow near that rate for the next five years. Still, its enterprise value-to-free cash flow multiple sits at 16. Introduced to Hidden Gems readers by guest analyst David Meier in August, it has risen 36% since his recommendation.

2. Ventiv Health (NASDAQ:VTIV) provides consulting, marketing, and salesforce services to pharmaceutical and biotechnology companies. Like Deckers, Ventiv also has a Gems tie-in. It was featured on Tom Gardner's Watch List back in late February. Though up about 50% since, Tom thinks there's still potential here as investors begin to look past discontinued operations, which have been carried on the books and have been a drag on overall results.

3. The oil and gas industry has decent representation on the F8 list, and NS Group (NYSE:NSS) is the most interesting to me. This company serves the entire energy industry with welded and seamless tubular products that are primarily used as casing during the drilling of wells. It also carries a Performance ranking of 1 in Value Line's Small and Mid-Cap Edition, meaning it has a better-than-average chance of outperforming the market over the next six months.

4. Hansen Natural (NASDAQ:HANS) makes energy drinks, bottled juices, natural sodas, and vitamin-fortified beverages. The company was first brought to my attention on the discussion boards by a disc jockey in a Key West strip club! He said all the employees in the club loved the products. Revealing! This also carries a Value Line Performance ranking of 1.

Don't stop here...
I hope something in the list caught your eye and that you'll allocate a portion of your portfolio to small-cap stocks. I truly believe that, over time, they will help boost your overall returns.

Tom Gardner's small-cap recommendations have averaged a total return of 30% since he began piloting Hidden Gems in June 2003 (vs. a 3% gain for the S&P 500). You can see exactly how he chooses and values small companies with a 30-day free trial to the newsletter. I know you'll find it enjoyable. If not, it won't cost you a dime.

Rex Moore developed the Modified Foolish 8 screen and presents it each month in Hidden Gems. He owns no companies mentioned in this column. The Fool is investors writing for investors.