"Buy low, sell high."
-- Anon.
We all know this investing mantra. We all see the Dow selling at levels last seen nearly a decade ago, just post-Bubble Burst. And we all have just one question: With stocks priced so obviously "low" right now, which ones should we buy, in hopes they'll go high?
Five years ago, as shellshocked markets began digging themselves out from the rubble of an imploded e-conomy, I asked myself this question -- and found the answer in Motley Fool Hidden Gems. At the time, as a recent subscriber to the Fool's small-cap investing service, I watched Tom Gardner's favorite stocks rocket higher -- beating the market by sizable margins per pick -- and I wondered: Are these guys just lucky?
How do they crush the market's returns so convincingly, and so often? The answer to that question became a column published on this website: 7 Steps to Finding Gems.
Times change, value doesn't
Over the years, that column generated a lot of feedback from Fool readers. Initially it was positive feedback, but as the years wore on, I received more and more emails advising that the websites I cited as resources for "finding gems" had disappeared. Bankrupt, discontinued, or changed beyond recognition -- these tools had become dull.
And yet, the investing philosophy that helped rebuild my portfolio remains as sharp as ever. So today, I'm going to reconstruct that column for your benefit -- and lay out once again the seven steps to finding winning small-cap stocks, using a few new tools. Onward.
What you want to find
When searching for potential "gems," I focus on the same small-cap sphere that our team at Hidden Gems explores. My ideal investment has:
- A market cap less than $2 billion, so it's got plenty of room to grow.
- Little or no net debt, because bankruptcy risk is a headache no one needs.
- Long-term growth prospects of 15% or better, a history of similar growth, and similar returns on equity -- because stagnation and inefficient management are no friends to the investor.
- Last but not least, management with "skin in the game," as represented by insider ownership of 10% or better.
The stock market's recent revival has thinned the ranks of such prospects, but if you know where to look, you can still find a handful. So here's what we are looking for, in seven easy steps:
- Market cap
- Net cash
- Enterprise value
- Free cash flow
- Historical and projected earnings growth
- Return on equity
- Insider ownership
Where to find them
Nearly every metric named above can be found quickly and easily on the pages of Yahoo! Finance. Let's take an easy example -- Yahoo! (NASDAQ:YHOO) itself.
Step 1: Looking for the market cap? It's right there at the top of the page: $20.2 billion.
Step 2: Net cash? Head over to the balance sheet to find the firm's cash and its debt, subtract the latter from the former, and voila: $3.38 billion.
Step 3: Enterprise value? Easy-peasy. Subtract net cash (or add net debt) to the stock's market cap, and that's the price of "the business." In Yahoo!'s case, it works out to about $16.82 billion.
Step 4: Free cash flow is actually two steps. Yahoo!'s cash flow page will show you the firm's operating cash flow and capital expenditures; subtract the latter from the former and you will find Yahoo! generating $1.2 billion in cash profits per year.
Steps 5, 6, and 7: Yahoo! will also tell you a stock's past and projected future growth rates (here), its return on equity (here, under "Management Effectiveness"), and the level of insider ownership (here, under "Share Statistics").
What next?
Now that you know the metrics to seek, and where to find them, two paths open up. If you already have a stock you're considering buying, head on over to Yahoo! Finance and see whether it checks out. Alternatively, if you're looking for ideas, give the stock screener over at Finviz.com a whirl -- a recent test run revealed such intriguing ideas as software vendor Synaptics (NASDAQ:SYNA) and sandwich hawker Panera (NASDAQ:PNRA), both of which made the cut.
Feel free to tweak the screen a bit. Raise your target market cap and you'll find larger companies like China Mobile (NYSE:CHL) and Apollo Group (NASDAQ:APOL) selling for cheap.
Loosen the stricture on insider ownership (because the bigger the company, the harder it is for management to afford a large stake) and both priceline.com (NASDAQ:PCLN) and Apple (NASDAQ:AAPL) look ripe for picking.
Simplify, simplify
Now, I should also mention that the metrics described above are not the only ones worth ... um, mentioning. For instance, the team at Motley Fool Hidden Gems uses a more sophisticated version of free cash flow, termed "owner earnings," to gauge companies' cash-generating prowess. Similarly, return on invested capital (ROIC) is a great tool for analyzing companies that carry lots of debt.
But while more math-intensive metrics exist, I prefer to "simplify, simplify." After all, there are more than 4,500 small-cap companies currently trading in the United States -- and time's a-wastin'. The seven steps outlined above give you a quick way to start sifting through the possibilities in search of tomorrow's winners. And, if and when you decide you're ready for something more advanced, my colleagues at Hidden Gems will be happy to help out.
Heck, if you ask real nice, they might even give you a free 30-day trial.
This article is derived from two previous articles published -- in much more verbose form -- way back in 2004. It has been substantially whittled down to make for easier reading.
Fool contributor Rich Smith owns shares of Priceline.com, but does not own shares of any other company named above. Apple and priceline are Motley Fool Stock Advisor recommendations. The Motley Fool has a gem of a disclosure policy.
