After the sky fell and the market crashed this past autumn, we've begun to see glimmers of stabilization in certain corporate earnings reports. Second-quarter GDP contracted at a mild 1%, compared with the steep declines in the first and fourth quarters, signaling the recession may be easing. With hope on the horizon that the economy is bottoming, the stock market is anticipating recovery. While this isn't a garden-variety recession and recovery could be bumpy and slow, stocks traditionally begin to appreciate before the actual recession is over. As a result, that means positioning your portfolio before the recession and bear market is over for the new bull market and economy.

In fact, small caps generally lead the broader equity market out of downturns, and it might be time to start positioning your portfolio in small caps. The Russell 2000, the small cap stock benchmark, has run up a whopping 65% since its March 9 low; however, the index still remains 33% below its peak in October 2007.

According to Russell Investments analyst Mary Fjelstad, over the four recessionary periods in the U.S. since 1979, on average, the best time to invest in U.S. equities – small-cap stocks in particular – was far in advance of the end of a recession.

"Historical research has tested that, on average, small-cap stocks led large caps at twelve, nine, six and even three months prior to and after a recession's bottom, as well as at the exact moment of the trough itself," according to Stephen Wood, Senior Portfolio Strategist at Russell Investments. "Investors who loaded up on small caps relative to large caps three and six months prior to the bottom and those who timed the bottom perfectly, had on average the best returns."

Building up small-cap exposure
For the long-term investor, trying to time that inflection point in the market clearly isn't necessary. In fact, small caps have a tendency to outpace their larger brethren as the economic operating environment improves. Case in point: Since the March 9 low, the Russell is up 65%, while the Dow is up 40%. So let's start searching!

To uncover winning small-cap companies, I ran a stock screen using the Motley Fool's CAPS screening tool. I looked for companies with:

  • Market caps between $100 million and $2.5 billion.
  • Return on equity of 17% or greater.
  • Current ratio of one or more, meaning the companies would be able to cover their obligations at least one time over.
  • Minimum earnings and revenue growth rates of 10% over the past three years.
  • Long-term debt-to-equity ratio of a maximum of 1, as it is more difficult for smaller companies to obtain credit in this market.
  • Price-to-earnings ratio of 20 or less.
  • CAPS ratings of five stars, the highest ratings from our CAPS community.

Here's what I uncovered (and you can see the screen here -- remember that results will be updated as the market changes):

Company

Market Cap (in millions)

Price-to-Earnings (TTM)

LT Debt-to-Equity Ratio

Current Ratio

EPS Growth Rate (last 3 Yrs)

Rev. Growth Rate (last 3 Yrs)

Return on Equity (TTM)

Almost Family
(NASDAQ:AFAM)

$249.8

12.8

0.25

1.3

20.78%

37.05%

19.2%

AZZ
(NYSE:AZZ)

$457.1

11

0.5

3.8

46.45%

24.48%

20.9%

China Natural Gas
(NASDAQ:CHNG)

$276.0

9.4

0.34

2.5

67.03%

111%

22.2%

Core Laboratories
(NYSE:CLB)

$2,058.1

15.1

0.86

3.4

37.65%

11.6%

59.5%

Graham
(AMEX:GHM)

$134.0

9.1

0

3.1

58.37%

18.3%

25%

Jinpan International
(NASDAQ:JST)

$273.5

13.3

0

2.2

55.81%

43.94%

19.1%

Wonder Auto Technology
(NASDAQ:WATG)

$320.6

15.9

0.09

1.2

55.77%

60.28%

19.5%

Source: Motley Fool CAPS screen. TTM = trailing 12 months. 

Aside from exhibiting robust financials, look for companies with unique products or services that produce great competitive advantages going forward. These attributes should put a company in a good position to pick up market share. Small caps that offer products that are unique are also better positioned to withstand the current economic conditions. After all it is these attributes that lead to the strong top and bottom-lines.

As always, using a screen through Motley Fool's CAPS resource center is a great way to start, but should be built upon through your own research. Remain mindful of the stock's valuation, fundamentals, and growth prospects.

Start digging for small caps at Motley Fool CAPS today! Let the collective wisdom of our 130,000-member-strong investment community help you make better investing decisions.

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Jennifer Schonberger does not own shares of any of the companies mentioned in this article. Jinpan International is a Motley Fool Hidden Gems selection. The Motley Fool has a disclosure policy.