Keep an Eye on These Little Guys

With the NCAA basketball tournament under way, you might be anxiously poring over your bracket, trying to decide which teams will be able to pull off the big upset.  It’s inevitable --- every year, one of the “little guys” knocks off a team from a power conference.  Afterwards, you always have to wonder how all the analysts missed that team. The same goes for stocks.

There are a few great basketball prognosticators who follow the game closely enough to know which teams are capable of pulling off a big upset. By the same token, there are also investors who make huge returns by finding overlooked small-cap stocks, and discovering signs of greatness before the rest of the market takes notice.  People often forget that companies such as Microsoft (NASDAQ:MSFT), Dell (NASDAQ:DELL), and Wal-Mart Stores (NYSE:WMT) were once small caps as well. They produced phenomenal returns for early investors. 

Even if you don’t find the next Wal-Mart, there are still a lot of reasons to invest in small caps.  With fewer people following them, these stocks are more likely to be “mispriced” by the market.  And as the recent stumbles of corporate goliaths such as AIG, Citigroup, and General Electric amply prove, these companies' enormity makes it difficult even for highly knowledgeable investors from large institutions to completely understand their businesses. Individual investors have even worse odds. A good small-cap company offers you a much better chance of understanding its operations.

Let’s use CAPS screener to search for small-cap stocks that might hold big-league potential. We'll focus on highly rated companies that have strong earnings growth (a difficult feat in this economy!) and a solid return on equity. If they're trading at a healthy discount, all the better. Here are my metrics:

• CAPS rating of four or five stars.
• Market cap between $100 million and $1 billion.
• More than 50% below 12-month high.
• EPS growth of more than 10% over the past three years.
• Return on equity greater than 15%.

Here are some candidates from the 80 companies that surfaced in my search. (You can run this screen yourself, and modify it as you like.)

*Data from Motley Fool CAPS as of March 24, 2009.

In our Motley Fool CAPS community, one of the companies in our screen, Sun Hydraulics, prompted this excerpt from the following analysis by CAPS all-star Pencils2, circa January 2008:

Sun is doing something right, because since fiscal 2002 operating efficiency has strongly increased. The company's been a very consistent producer of cash flow as well as free cash flow over the past several years as well. The company has been able to use this cash to both expand the business and strengthen the balance sheet, which currently sits with $17.21 million in cash with only $750K in debt … A lot of things seem to be clicking for Sun operation-wise. Internationally the company still has huge expansion possibilities (China expansion has just started and India most likely will be soon) and the company is in a fabulous financial position to take advantage of those opportunities.

That gives us a great starting point to focus our research. With hard work and a little luck, we might just find a good underdog investment to upset the market. 

Further small-cap Foolishness:

• Dream Stocks for Small Cap Investors
• Small Cap Companies and the Stimulus Plan
• Why This Strategy Wins