Lessons From the 10 Best Small Caps

Here at the Fool, we're always looking for easier ways to find the winning stocks of tomorrow. And whether you're a value type or a growthie, sooner or later your attention turns to small caps, where the big gains are possible. What's the secret to identifying these market beaters early enough to make us all rich?

Try as you may
In The Market's 10 Best Stocks, fellow Fool Tim Hanson showed that the past decade's biggest gainers started out small and obscure. Because the markets naturally put upper limits on companies, it follows that the biggest growers had to begin small. But with thousands of small- and micro-cap companies vying for our investment dollars, what do we make of that information? In a follow-up article, Tim found a compelling link between performance and management tenure. I think he's on to something. (His work also suggests that the net cash or debt position doesn't matter much.)

Bill Barker took an interesting swing at the subject in 70 Times Better Than the Next Microsoft. He showed that small-cap value was a champion performer over the long run, beating small-cap growth and large-cap growth and value. Unfortunately, those returns required a 78-year holding period, frequent portfolio rebalancing, and other conditions that would be difficult to duplicate in a real-money portfolio.

I spend a good deal of time sifting through similar data in an effort to find the next big thing for my portfolio, so today I figured I'd share one of the lessons I've learned from the effort.

A real-world effort
To coincide with my usual target holding period, I screened for the best small caps of the past five years -- companies that began the period with market caps between $300 million and $2 billion. The hunt was narrowed by two more factors, criteria I find eminently reasonable in the real world. First, I took only stocks that trade on the New York Stock Exchange or Nasdaq. Second, assuming most of us like to avoid major money pits, I chose companies that had positive cash from operations at the beginning of the period. Here are the results.

Of course, this list only looks backward. It doesn't tell me anything about where I should be investing for tomorrow.

To find answers to that question, I tried to figure out what these companies looked like in the two years before they started those amazing five-year runs (that is, from 1998 to 2001). Were there any similarities or patterns? Were there criteria we can cull from these winners to apply to the market today, so that five years from now, some of what's in our portfolios will appear on the top 10 small-cap list? Do we see budding free cash flow? Earnings climbing? Margin improvements? Sales ramping through the roof?

Consistent inconsistency
I hate to sound like a bad roll of the Magic 8-ball, but the answer is hazy. Before those five-year runs, these 10 companies were all over the board on earnings: two sported negative earnings growth, and two more had minuscule gains. The story was the same for free cash flow and revenues. Only one of these companies would have looked like a great buy to me -- Thor Industries, which had 30% earnings-per-share growth yet traded at a price-to-earnings ratio of 9. Chico's should have tickled my fancy as well. Although it traded at steep multiple, it was sporting better than 100% annual earnings growth, on revenue growth of 51%. It was one of the few examples of a sprinter that just kept on sprinting.

Does this lack of clarity mean there is no magic formula? I think it's OK to entertain the notion that there isn't. But I don't think that means you give up digging for promising small caps. It just means the digging is different.

My own stint from the land of small caps has convinced me that biggest successes come from spotting the complex situations, the companies that are about to turn -- the very ones that defy screens. I was treated to a three-bagger with Guess? because my wife pointed it out as a curiosity. We looked at the financials and discovered a turnaround that was actually turning around nicely. We found that the free cash flow we cherish in growing companies was on the way, and that's why the stock responded.

One of the earliest and most successful Motley Fool Hidden Gems recommendations, Middleby, came from a similar situation. The Street underestimated and misunderstood its realignment a few years back. But the oven maker has since benefited from what I see as an even more promising trend -- the worldwide appetite for dining out. Finding turnarounds with better-than-average revenue growth potential can provide some really high-octane stock returns, as Middleby's 355% appreciation since November 2003 shows.

The Foolish bottom line
The criteria that power returns, like growing revenues, profits, and cash flow, aren't always apparent before the run. But by digging deeper, you can find companies about to move on to great things. (I know, because even I have done it.) Best of all, the odds are even better in smallcapland, where there are fewer experts paying attention.

So don't forget to screen for the obvious, but also don't forget that the big-returning small caps in the list above demanded a lot more research, understanding, and faith than the numbers suggested at the time.

Consider investing where others see problems, or where others don't see at all. And if you'd like to learn how Hidden Gems beats the market by digging deeper and looking where the market won't, a free one-month guest pass is available.

Seth Jayson once owned shares of Chico's but sold out for a paltry 50% gain. At the time of publication, he had shares of Guess?, but no positions in any other company mentioned here. View his stock holdings and Fool profile here . Coventry Health Care and PetSmart are Motley Fool Stock Advisor recommendations. Fool rules arehere.