One of the primary reasons that companies go public is to get cash to expand. They want to get bigger. They have a plan and a team in place for success. But they need more money than they currently generate from their existing operations. By issuing shares to the public, they:

  • Receive an essentially unrestricted infusion of cash.
  • Pay no interest on that money.
  • Get financed by people who will be directly rewarded for their successful expansion.

It's a win-win situation for the business that needed the money and its new investors that share in the benefit of that company's growth. From the company's perspective, it's often a better alternative than taking on debt to finance expansion. After all, debt can come with restrictive covenants on the use of the money and requires prompt interest payments.

Avoid the pitfalls
Of course, things don't always work out as we had hoped. Small companies can fail if their plans get derailed. And even if their businesses do succeed, the possibility of excessive dilution can mean that shareholders simply won't realize the growth they hoped for. That said, you need to proceed with caution when looking to buy these smaller firms.

Fortunately for you, though, there are ways to help improve your odds of success. By focusing on small companies that are already profitable, have strong balance sheets, and enjoy significant insider ownership, you can avoid most of the major stinkers. Using this tact, you can take advantage of the tremendous opportunities in small caps while limiting the risks that often afflict the segment. Stocks with these characteristics are exactly what lead analysts Tom Gardner and Bill Mann look for when they're searching for companies to recommend to Motley Fool Hidden Gems subscribers.

Why it works
Profitable companies, for instance, are much less likely to return to the capital market to get more money. Firms with strong balance sheets have the financial flexibility to help them weather a storm that might otherwise derail a weaker player. And businesses with significant insider ownership are less likely to excessively dilute their shares. After all, such dilution would harm the insiders as much as it would the outside owners, if not more so. Plus, strong insider ownership helps assure that the company's management is truly passionate about the company, since a significant part of their net worth is tied up in its success.

By finding companies with the trifecta of all three key factors in their favor, you position yourself in a great spot to assure you can share in their successes. Add the tremendous growth potential of small caps to that solid financial foundation, and you've got yourself a great recipe for long term, total investing success. Here are just a few companies that look to fit the bill:


Working Capital

TTM Earnings






Heartland Payment Systems (NYSE:HPY)




Quality Systems (NASDAQ:QSII)




DealerTrack (NASDAQ:TRAK)




Hittite Microwave (NASDAQ:HITT)




Coldwater Creek (NASDAQ:CWTR)




Dril-Quip (NYSE:DRQ)




With strong balance sheets, positive earnings, and solid insider ownership, each of these companies is well positioned both to excel and share their successes with shareholders.

If you're serious about finding the best small companies to own, you need to make sure you know how to look for great companies where management's incentives are aligned with yours. Finding just those businesses is how Hidden Gems has trounced the market since its 2003 launch. If you'd like to see our favorite small-cap companies and research, join us today with a free 30-day trial.

At the time of publication, Fool contributor Chuck Saletta did not directly own shares of any company mentioned in this article, but his wife owned shares of Heartland Payment Systems. Zumiez is a Motley Fool Hidden Gems pick. Quality Systems is a Stock Advisor choice. The Fool has a disclosure policy.