Small-Cap Report Card: How It Works

We've all heard that "good things come in small packages." But the investing version of that maxim might be, "great returns come from small companies."

Finding small companies is easy -- just set up a screen that looks at market capitalization. But finding the good ones? That's why I built the Fool's Small-Cap Report Card, with the help of Andy Cross, co-advisor of the Motley Fool Hidden Gems small-cap investing newsletter and portfolio.

Small-cap companies, those between roughly $250 million and $2 billion in size, offer some of the best returns around as they become the large caps of tomorrow. It's pretty tough for a company worth $200 billion or more like ExxonMobil or Apple to increase in size by 500%. But for a well-run small cap, that big a gain is potentially just the beginning.

But did you notice the phrase I slipped in there -- "well-run"? The key to finding the good small-cap companies that can give outsized gains lies in those words. The report card does this by grading companies in three areas:

1. Management.
2. Competitive advantage or "moat."
3. The numbers.

It starts with management
In any company, but especially small ones where management wields more influence, we want management aligned with all stakeholders, particularly shareholders.

Tenure / Experience: First, they should have extensive industry experience, either running the company for several years or working at similar companies. The skills in one industry aren't necessarily transferrable to another. The score runs from 0, where the CFO and CEO average less than a year with the company or industry, to 5, where the average is 10 or more years.

Company ownership: Managements' own interests should be aligned with shareholders by having a significant portion of their personal wealth tied up in the company. Founders often do, but newcomers arrive. In any event, I'd like to see at least $10 million in ownership. With at least that much held by the CEO, the company will score a 5, going down from there with less and less at stake.

CEO compensation: Because small caps often don't have a huge revenue base, I don't want to see a lot of that revenue going into the pockets of management and not making it to the bottom line. An annual salary of $1 million is a pretty reasonable level, and a score of 5 would be awarded for salaries at or below that level. More highly paid execs, though, will be penalized.

Aggressive accounting: Finally, I'd much rather see that management is aggressive about growing the business, not about the accounting. Aggressive accounting is often a sign that management is more worried about the "numbers" and less worried about the business behind those numbers. Stuffing inventory channels in order to recognize revenue sooner when sales are slow is one instance. One of the early signs of aggressive accounting is when cash flow from operations, the cash actually moving into the business, lags net income. That can happen on occasion, but for the vast majority of the time, CFFO should exceed net income. The scoring here is how many years of the past five where this relationship held true.

It continues with competitive advantage
Of course, having the best management in the world doesn't help the investor if the company doesn't have a competitive advantage that will contribute to growth. This is the "moat" that Warren Buffett is so fond of talking about. Here, I'm going to use the return on capital and look at the trend over the past several years. If the moat is eroding, competitors are coming in and the returns will start declining. Again, the score is the number of years out of the past five where ROC held steady or increased.

Don't forget the numbers
Here, I'm obviously looking for both revenue and net income growth over the years, but also free cash flow growth, as that is the money investors actually have a claim on. There are a couple of other items as well:

• Debt-to-equity ratio -- lower means they can more readily survive bad times.
• Operating margin steady or improving, year over year -- containment of both cost of goods and costs of running the business.
• Revenue growth, year over year.
• Net income growth, year over year.
• Free cash flow growth, year over year.

Except for debt, I'm looking at multiyear trends. For the scores in this section, I'll give them one point for each year out of the past five when they grew the metric year over year. And of course, low D/E ratios score higher.

The final grade
To give you a sense of how it looks at the end, here's an example:

That grade is determined by the following total score ranges:

I hope you find the small-cap report card to be a helpful research tool.