Source: Federal Reserve Bank of New York.
Small-cap stocks -- here defined as publicly traded companies with market valuations ranging from $250 million to $1 billion -- offer a unique risk-versus-reward proposition for investors.
On one hand, small-cap stocks often present added risks that larger companies don't. Many of them are losing money, have cloudy long-term outlooks, or face uphill battles in a competitive sector. And given that larger stocks are much more likely to pay a dividend, there aren't as many incentives for long-term investors to buy into small-cap stocks.
However, small-cap stocks have a wildcard in their back pocket: growth potential. It's a lot easier for a company to grow its sales from $100 million to $200 million than it is for a blue-chip corporation to double its revenue from $100 billion to $200 billion. Therefore small-cap stocks can potentially offer the greatest stock-price appreciation.
Nearly 1,400 stocks fall within the $250 million to $1 billion market-cap range, making it difficult and tedious to hunt down the best small caps. However, the reward for uncovering a hidden small-cap gem can be enormous.
With that in mind, here are three currently unknown small-cap stocks that you should have on your radar.
Source: Flickr user Roy Niswanger.
Alliance Fiber Optic Products (AFOP +0.00%)
Sporting a market value of $315 million, fiber optic components supplier Alliance Fiber Optic is being covered by just two Wall Street firms, yet its share price has skyrocketed 278% over the trailing five-year period.
What makes the company so intriguing is the ongoing expectation of explosive growth in data center demand. As the storage and speed needs of businesses grow, the demand for infrastructure should grow in step, benefiting fiber-optic component suppliers like Alliance Fiber Optic. The company has especially benefited from overseas growth in China and will likely continue to do so, barring a substantial slowdown in the Chinese economy.
Alliance Fiber Optic's top line expanded from $30 million to $86 million between 2009 and 2014. By fiscal 2016, revenue is expected to reach $105 million, again assuming that demand for data center solutions remains relatively steady.
Alliance Fiber Optic Products also has a rock-solid balance sheet complete with $57.9 million in cash and cash equivalents, as well as another $10.7 million in long-term investments -- and no debt. In other words, about 20% of the company's value is comprised of cash. Not surprisingly, Alliance Fiber Optic announced a share buyback program in August that could work out to as much as $25 million worth of its shares.
Valued at 13 times forward earnings, this unknown small cap in the tech sector should be on your radar.
Source: National Cancer Institute.
Geron (GERN 5.11%)
In the biotech sector, I'd encourage small-cap enthusiasts with the highest levels of risk tolerance to keep their eyes on clinical-stage drug developer Geron, which currently boasts a $470 million valuation and has just four Wall Street firms covering it.
There are obvious risks that come with investing in a clinical-stage pipeline. For example, there are no guarantees that any of the pipeline products will succeed, and a clinical-stage biotech could very well continue to burn through its cash on hand. In Geron's case, the added risk is that its pipeline consists solely of a single experimental drug, imetelstat. If this experimental drug fails in clinical trials or isn't approved by the Food and Drug Administration, Geron could lose most of its market value.
The reason I'd suggest you keep this relative unknown on your radar is that imetelstat did something in clinical studies that no drug has done before: It elicited partial and complete responses in patients with myelofibrosis, a rare type of bone marrow cancer that leads to scarring.
The existing treatment on pharmacy shelves for myelofibrosis is Jakafi, a JAK2 inhibitor that led to spleen size reduction in clinical trials. However, Jakafi's purpose is to lessen symptoms of the disease, not to provide any curative benefit. Imetelstat, on the other hand, led to a 41% overall response rate in an early-stage study conducted by the Mayo Clinic. In recently released results from a phase 2 pilot study, imetelstat led to the reversal of bone marrow fibrosis.
Lastly, Johnson & Johnson partnered with Geron (likely recognizing the potential for imetelstat) in a collaborative deal worth as much as $935 million, including $35 million in up-front cash. If imetelstat can overcome its prior safety concerns, it could become the go-to therapy to treat myelofibrosis.
Source: Flickr user Cliff.
SkyWest (SKYW 0.59%)
I'd also suggest looking to the skies to find potentially lucrative small-cap investments. SkyWest, a regional airline that handles in the neighborhood of 3,500 daily departures throughout North America, Mexico, and the Caribbean, like the other small-cap stocks listed above, has just a handful of Wall Street firms following it. However, Wall Street's indifference could be to your benefit.
SkyWest, which operates its flights in agreements with other airline companies, has a number of catalysts working in its favor that could send its share price substantially higher over the long run. First, lower fuel costs have added an extra boost to SkyWest's bottom line. Fuel costs have been airlines' biggest concern for years, but the precipitous drop in oil prices, and the lack of any substantive rebound, means that airlines could enjoy low prices and high margins for quite some time.
Labor issues are also not a concern. Whereas labor contracts have stymied growth for some of the major airlines in the past, SkyWest recently announced that it has locked its pilots in for a three-year term. Best of all, both sides seem happy with a salary increase for the pilots so that SkyWest can move beyond a potential disruption in operations.
Finally, SkyWest is in the process of updating its fleet with larger-capacity aircraft in order to take advantage of growing travel demands. The transition has definitely created a little turbulence in its recent traffic numbers, but it could ultimately make for a great opportunity to pick up shares of SkyWest during a bout of temporary weakness.
A forward P/E of nine and a dividend yield of around 1% are all the more reason to keep this airline on your radar.
