One Small Cap for the Coming Rally

It seemed as though the bloodletting would never end, but the market finally turned on March 9 of last year. There have been a few blips and bumps on the ride back, but the S&P 500 is up more than 60% since the rally began. One of the most common questions I'm receiving now is, "What stocks should I be in now?"

Aston River/Road Asset Management senior portfolio manager Andrew Beck recently told The Wall Street Journal, "Small caps tend to lead coming out of a recession, and we're now transitioning to that period where the market tends to be led by larger stocks of quality."

That pretty much sums up the common wisdom, and we agree with most of it. Most of it. The brisk, post-March 9 rally was in large part boosted by lower-quality small caps that had been brutally hammered during the credit crisis. What's more, they were hammered fairly; they were, after all, mostly overleveraged and poorly managed companies that investors knew had a real chance of going to zero -- bankrupt. When the crisis eased and it became apparent many would survive, it was natural to see them skyrocket from their lows.

One way to illustrate this is with the well-known and very predictive Altman-Z metric. An Alt-Z score below 1.8 indicates a strong possibility of bankruptcy for a company. I did some research and found that Capital IQ lists 1,043 publicly traded small caps with scores below 1.8 in the first quarter of 2009. Yet since the market turned, those distressed companies have thus far returned an average of 272%. Here are a few of those winners:

Data provided by Capital IQ, a division of Standard & Poor's.

The companies listed above still have some problems, with Alt-Z scores still below 1.8, more debt than cash, and negative earnings over the last 12 months.

In the meantime, there were 1,235 small caps on March 9 with Altman-Z scores above the danger zone. But this group has averaged only 133% gains in the ensuing rally -- roughly half of what the distressed group has returned. Investors in companies like these could only watch as the troubled companies left them behind:

Data provided by Capital IQ.

While not all 1,235 companies in this group could be considered high-quality, the above are. Each still has a comfortable Alt-Z score, more cash than debt, and high returns on equity.

Although distressed and deeply troubled small-caps have averaged better than a triple since the market turned, that particular small-cap rally is over and done with. While those 1,043 low-quality companies are breathing easier, many are still saddled with debt and the same management that got them in hot water in the first place. That's why many investors are now looking to larger, slower-growing companies for the next leg of the rally.

Not so fast ...
But -- we don't think you need to give up the awesome potential of small caps to participate in any wider rally that may be coming up. After all, there are small caps out there that are extremely well-managed, have little or no debt, and that operate with competitive advantages that even the big boys admire.

Even better, the companies I'm talking about were left behind when their fellow small caps were rallying. Yes, that's right: Many high-quality, built-for-dominance small caps were left treading water while fragile, troubled companies were doubling and tripling off their lows.

What that leaves us with today is something beautiful indeed: Underpriced, quality small caps that should soon catch the attention of institutions and individual investors alike.

For instance
Now, how about that stock I promised in the headline? Our team of small-cap experts at Motley Fool Hidden Gems has tabbed FormFactor for exactly the reasons mentioned above. This maker of semiconductor testing equipment is well-positioned for the long-term boom in the chip sector. It has a competitive advantage in the form of patents and sports a nearly debt-free balance sheet. What's more, the stock has lagged far behind the general market rally, and the Gems team thinks it's trading well under fair value -- thus making it a Buy First recommendation.

You can read more about FormFactor and see the nine other Buy First stocks free for the next 30 days. Here's more information.

This article was originally published March 8, 2010. It has been updated.

Fool analyst Rex Moore fought beside Davy Crockett at the Alamo. Rex owns shares of Buffalo Wild Wings. FormFactor and Buffalo Wild Wings are Motley Fool Hidden Gems picks. Motley Fool Options has recommended a bull call spread on FormFactor. The Fool owns shares of FormFactor. The Fool has a disclosure policy.