Screening for Great Small Caps

This article is part of our Rising Star Portfolios series.

Last week, my multivitamin portfolio picked up seven shares of Coca-Cola at a price of $63.41. As I explained in the buy report, I bought half a position, or about $500 worth. I'll be keeping an eye on Coke for the proper time to finish off the bottle and fill out the full position, but now it's time to move on to something else.

Before we choose our next direction, it's worth knowing where we're aiming to end up. I've said that this portfolio will be well-rounded and diversified across all company sizes and industries. I'll accomplish this by following some guidelines from my good friend and Rule Your Retirement advisor Robert Brokamp.

In his service, he recommends certain allocations based on how far away from retirement you are. Doing some extrapolating, incorporating rounding errors and carrying of decimals, here's what we'll aim for:

I'm not going to be a stickler about hitting these percentages; this is just a general guideline. If you're getting close to retirement, you might want to dial back a bit on the small-cap and international exposure. If you still have a couple of decades or more to go, consider pushing the risk a bit and increasing that exposure. You've heard this before, but it's really all up to you and how much tolerance you have for risk.

Getting small
We've done a large cap, so now let's head to the opposite end of the spectrum. Whenever I'm looking for small caps, I use a couple of powerful screens that have produced proven winners in the past: the Foolish 8 and the Modified Foolish 8.

Foolish 8: Developed by Fool co-founder David Gardner and published in the first edition of The Motley Fool Investment Guide to identify profitable, rapid-growth, small-cap stocks -- using these eight criteria:

1. Revenues: $500 million or less
2. Earnings and sales growth: 25% or greater
3. Net profit margin: 7% or greater
4. Daily dollar volume: $1 million to $25 million
5. Insider holdings: 10% or greater
6. Share price: $7 or greater
7. Relative strength: 90 or greater
8. Operating cash flow: a positive number

According to the independent American Association of Individual Investors, the Foolish 8 has a 341% total return since the beginning of 1998. That's a nice 12% annualized return, especially when compared to the S&P 500's 1.5% annualized gain. The AAII methodology involves buying a stock the month it passes a screen and selling when it's off, which is something we'd never do. Still, this performance points to the strong potential of the screen.

Modified Foolish 8: Several years ago, I modified the F8 screen to add some elements of valuation and management effectiveness. Here's a summary of the changes I made:

1. Raised the revenue cap to $900 million or less.
2. Took the $25 million limit off the daily dollar volume requirement, making it simply $1 million or greater.
3. Loosened the relative strength requirement to 50 or greater.
4. Required not only positive cash flow, but also positive free cash flow.
5. Required a price to free cash flow-to-cash flow growth (PFCF-to-FCF growth) multiple of 1.00 or less.
6. Required better than 15% return on equity (ROE) over the last four quarters, and for each of the last three fiscal years.

I hit the jackpot with the screen. The AAII charts a 1,002% total gain for the Mod-8 since 1998 began, for an outstanding 20% annual growth rate.

The contenders
Here are the companies passing each screen:

Foolish 8

Source: Capital IQ, a division of Standard & Poor's.

Modified Foolish 8

Source: Capital IQ, a division of Standard & Poor's.

Until next time...
These are the candidates for our next buy. My time is up, so we'll dig into the companies in my next column. There are a few different ways to keep up with this multivitamin portfolio, including following me on Twitter and checking out our own discussion board. Why not give them both a try?

This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. See all of our Rising Star analysts (and their portfolios).