One of the questions I get most often as an analyst is, "How do you find the stocks you recommend?" There are actually a number of ways to generate ideas, but one of the best and most replicable for investors at home is screening. This means asking a computer to look for companies that fit several predetermined and desirable criteria.

The difficult part of screening, of course, is knowing what to ask the computer to look for. To help you out in that regard, I thought I'd share with you today one of the screens I use to find great micro-cap stocks for our Motley Fool Hidden Gems research service. As an aside, I'll just note that micro caps are among the most exciting segments in the stock market today. While it's definitely volatile, you won't find any other slice of the market that matches its potential upside.

A man working at a desk with a tablet and lots of financial charts

Image source: Getty Images.

Step 1: Identify a micro cap
The first thing one needs to do when looking for great micro caps is to start with small companies. For our purposes, that means any company with a market cap less than $250 million.

According to my screen, there are 2,433 companies trading on the major U.S. exchanges for less than $250 million. That's too many to be helpful, which means we need additional criteria.

Step 2: Identify a strong business
While there are any number of ways to identify a strong business, when it comes to micro caps, a strong balance sheet is one of the most important traits a company can have. That's because small companies don't have a lot of room for error, and cash is a safety net when the economy turns south.

From there, I also like to see a micro cap that's already free cash flow-positive. This generally indicates that the company has already figured out a sustainable business plan -- not a given for very small companies.

According to my screen, there are 381 micro caps with more cash than debt and positive free cash flow. That's still a few too many to be helpful, which means we need additional criteria.

Step 3: Identify a good value
Again, there are many ways to get after valuation, but there a few thumbnail measures -- such as Price-to-Earnings and Price-to-Book -- can be helpful in screening. I like to use Enterprise Value-to-EBITDA, which takes into account the state of a company's balance sheet, but omits charges that are not core to operations. Generally speaking, anything less than seven here gets our attention.

There are 146 micro caps trading for less than seven times EBITDA. That's still too many to be helpful, which means we need additional criteria.

Step 4: Identify a shareholder-friendly firm
This can be a difficult quality to screen for, but two proxies we use are insider ownership and whether or not a company pays a dividend. If a micro cap is significantly owned by its managers, and pays a dividend to shareholders, the company's interests are more likely aligned with those of outside investors.

By looking again for micro caps with better than 10% insider ownership and regular dividend payments, the screen returns with 27 names -- a manageable number to look over.

Our candidates
After glancing at each of the 27 promising candidates, here are 7 that caught my attention:

Company Name

Market Capitalization


Dividend Yield

Insider Ownership

Ecology & Environment (Nasdaq: EEI)





Communications Systems (Nasdaq: JCS)





Jinpan International (Nasdaq: JST)





Lacrosse Footwear (Nasdaq: BOOT)





Superior Uniform Group (Nasdaq: SGC)





VSE (Nasdaq: VSEC)





Todd Shipyards (NYSE: TOD)





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

Of all those stocks, the one that really pops out to me is Todd Shipyards. Its fixed assets offer a competitive moat, the stock looks dirt cheap at 3.6 times EBITDA, and it's a cash flow machine with minimal capital expenditure requirements. Hopefully, this company would consider raising its dividend as the shipping industry recovers.

But remember, screening is just the start of the research process. Savvy investors still need to look deeper at the numbers and investigate criteria one can't screen for, such as the market opportunity going forward. Foolish investors should also double-check the numbers that the screener thinks it's found. Jinpan, for example, has been suffering recently, because of competition in China and weakening global demand for its transformers

That said, I'll be looking at Todd Shipyards further, and bringing it up for discussion with our Motley Fool Hidden Gems research team. So that's one idea for you. If you're interested in starting to use screens yourself, check out our free Motley Fool stock screener.