What a difference 12 months can make. Last year at this time, we were staring at a market abyss. Right now, on the other hand, we’ve seen the market rise more than half of the way back to its all-time high, with small caps taking the lead.

Small caps generally lead the broader equity market into or out of downturns. For example, the small-cap stock benchmark, the Russell 2000, peaked in July of 2007; large-cap indices, such as the Dow and S&P 500, didn't peak until October 2007.

As we begin to emerge from this wretched recession, it's time for investors to gain small-cap exposure in their portfolios if they haven't done so already. The Russell 2000 has already run up a whopping 85% since its March 9 low; however, the index still remains 26% below its peak in July 2007.

"Historical research has tested that, on average, small-cap stocks led large caps at 12, 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 85%, while the Dow is up 61%. 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:

  • A market cap between $100 million and $2.5 billion.
  • Return on equity of 17% or greater.
  • Current ratio of 1 or more, meaning the companies would be able to cover their near-term obligations at least one time over.
  • Long-term debt-to-equity ratio of a maximum of 1, because it's 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 possible, from our CAPS community.

Company

LT Debt-to-Equity Ratio

Return on Equity (TTM)

Market Cap (in millions)

Price-to-Earnings (TTM)

Current Ratio

American Science & Engineering (NASDAQ:ASEI)

4%

18.4%

$703.00

19.6

4.5

AZZ (NYSE:AZZ)

47%

19.7%

$409.9

9.9

3.7

China Education Alliance (NYSE:CEU)

0%

31%

$172.8

10.0

16.6

China North East Petroleum (NYSE:NEP)

4%

22%

$234.7

12.0

1.5

Orchids Paper Products Company (NYSE:TIS)

35%

21.2%

$149.2

10.9

3.7

ShengdaTech (NASDAQ:SDTH)

47%

17.6%

$332.8

14.8

10.4

Tianyin Pharmaceutical (NYSE:TPI)

0%

18.1%

$107.4

13.0

5.8

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

Here's what I uncovered:

Besides robust financials, you want to 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 unique products 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. However, investors should be aware that smaller businesses don’t have the same “easy” access to credit right now that larger companies have. So be sure to check the individual company’s ability to borrow, or see if it has a credit line in place.

Also, aside from a company’s fundamentals at the micro level, you must remain aware that small caps are riskier by nature than their larger brethren. As a result, if there is rockiness in the macro economy and broader market, small caps’ gyrations will be magnified in comparison with large caps. The takeaway: Make sure to diversify between small caps and large caps within your portfolio.

As always, using a Motley Fool CAPS screen is a great way to start, but you should build upon it 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 145,000-member-strong investment community help you make better investing decisions.

If you love or hate any of the six companies listed above, please, share with the Fool community. Head over to CAPS or leave comments in the space below.

Further Foolishness:

Foolish contributor Jennifer Schonberger owns shares of ShengdaTech, but does not own shares of any of the other companies mentioned in this article. American Science & Engineering is a Rule Breakers pick. The Motley Fool has a disclosure policy.