To coin a phrase, "Great stocks come in small packages." That's especially been the case in December, when the Russell 2000 small-cap index finished up 5.5%, versus just 0.7% for the S&P 500.

Since small caps generally lead the broader equity market out of downturns, this recent outperformance is a positive sign. It might be time to begin thinking about positioning your portfolio in small caps to eventually ride the market out of its trough.

Bigger isn't always better
Bill Greiner, chief investment officer for UMB Asset Management and UMB Bank, and chief economist for Scout Investment Advisors, maintains that low consumer sentiment can foreshadow strong performance in small caps.

According to Greiner, over the last 30-year period, when consumer sentiment has registered below a level of 96, small caps have outperformed large-cap companies by close to 10 percentage points during the following 12-month period. The consumer confidence index slid to a new all-time low in December of 2008, down from 44.7 in November.

Building up small-cap exposure
In order to properly position your portfolio and take advantage of an overall market upswing, it's necessary to create a watch list of small caps. To uncover winning small-cap companies, I ran a stock screen using the Motley Fool's CAPS screening tool. I looked for companies with:

  • Market caps between $100 million and $2.5 billion.
  • Return on equity of 17% or greater.
  • Current ratio of one or more, meaning the companies would be able to cover their obligations at least one time over.
  • Minimum insider ownership of 5%.
  • Minimum earnings and revenue growth rates of 10% over the past three years.
  • Long-term debt-to-equity ratio of a maximum of 0.5, as it is more difficult for smaller companies to obtain credit in this market.
  • CAPS ratings of four or five stars, the highest ratings from our CAPS community. During the first 20 months for which we have data, four- and five-star companies have outperformed the market, with average annualized gains of 7% and 12% respectively.

Here's what I uncovered. You can see the screen here.

Company

Market Cap (millions)

LT Debt-to-Equity Ratio

Current Ratio

Insider Ownership

Return on Equity (TTM)

Capella Education (NASDAQ:CPLA)

$920

0%

3.7

12.3%

21%

Interactive Intelligence (NASDAQ:ININ)

$117

0%

1.8

25.9%

27%

K-Tron International (NASDAQ:KTII)

$221

0.2%

2.2

11.8%

22.2%

Masimo (NASDAQ:MASI)

$1,600

0%

4.1

17.8%

20.8%

Morningstar (NASDAQ:MORN)

$1,790

0%

1.9

61.5%

17.8%

Sun Hydraulics (NASDAQ:SNHY)

$306

0%

4.7

28.5%

25.9%

Source: Motley Fool CAPS screen.

While the recent trend has been positive, it may not be time to throw caution to the wind. Case in point: The small-cap index took off from May through early October 2008, leading the Dow and the S&P 500 during that time, only to cascade to the same depths as those indices.

For the long-term investor
If you're not keen on timing your portfolio for the coming bull market, small caps are merely a great way to get in on big winners early. Look for companies with unique products or services that produce great competitive advantages going forward. These attributes should put a company in a good position to pick up market share. Small caps that offer products that are unique are also better positioned to withstand the current economic conditions. Take jean queen True Religion (NASDAQ:TRLG), which is weathering the downturn better than its retail peers.

As always, using a screen through Motley Fool's CAPS resource center is a great way to start, but should be built upon through your own research. Remain mindful of the stock's valuation, fundamentals, and growth prospects.

Start digging for small caps at Motley Fool CAPS today! Let the collective wisdom of our 125,000-member-strong investment community help you make better investing decisions.

For related Foolishness:

On Jan. 12, 2009, Fool co-founder David Gardner, Jeff Fischer, and their Motley Fool Pro team will accept new subscribers to their real-money portfolio service. Motley Fool Pro is investing $1 million of the Fool's own money in long and short positions in a range of securities, including common stocks, put and call options, and exchange-traded funds (ETFs). They also incorporate proprietary CAPS "community intelligence" data into their research. To learn more about Motley Fool Pro and to receive a private invitation to join, simply enter your email address in the box below.

Jennifer Schonberger does not own shares of any of the companies mentioned in this article. Interactive Intelligence is a Motley Fool Rule Breakers pick. Morningstar is a Stock Advisor selection. Sun Hydraulics is a Motley Fool Hidden Gems choice. The Fool owns shares of K-Tron International and Morningstar. The Motley Fool has a disclosure policy.