Even in the context of one of the biggest and fastest advances in stock market history, small-cap stocks have outpaced the competition with strong gains. If you're a small-cap investor, you need to be careful to preserve your gains. With that in mind, ask a simple question: are there still small-cap stocks out there that are good values?
Waiting for the fall
After a huge rally that has lasted longer than many investors ever expected, the mood within the investing community seems increasingly tense. Some have felt pessimistic about the stock market and the U.S. economy ever since the bull market started, and after more than two years of watching the market rise, waiting for the other shoe to drop has become increasingly difficult.
When it comes to stocks, though, you can draw a line between large-cap and small-cap stocks. While the best known indexes of the biggest companies have recovered quite a bit of ground, most of them still rest far below their all-time highs. Yet the Russell 2000 index of small-caps rose to a new record last month and continues to flirt with those levels. So even among those who are fairly bullish on stocks overall, many think small-caps have come as far as they can and are overdue for a fall.
A stock by any other name
One mistake that many beginning investors make with small-caps is to assume that they are somehow fundamentally different from large-cap stocks. In contrast to well-known large companies that have been around for decades, many small-caps are still struggling to establish track records of their own in order to survive to the next level.
But even with small-cap stocks, the same analytical skills are still valuable. Knowing valuation metrics like earnings or free cash flow multiples can work well to identify small-cap stocks that are attractive enough as potential bargains to justify further research.
So as a very simple start to generate some interesting ideas, I used the screener at Motley Fool CAPS to find small-cap stocks with P/E ratios of 12 or less and good ratings from our CAPS community. Here are seven of the stocks that came up:
Long-Term Growth Estimates
BlackRock Kelso Capital
China Security & Surveillance
Sources: Motley Fool CAPS and Yahoo! Finance.
Even a simple screen like this reveals a wide variety of interesting candidates. But as always, you have to look beneath the numbers for more information before making a decision:
- As a specialty middle-market venture financing company, BlackRock Kelso Capital can see extremely lumpy earnings depending on shifting demand among its stable of customer companies.
- With the recent skepticism concerning Chinese small-caps, China Security fell so low that its management team decided to do a leveraged buyout.
- With both Diana and Taseko, forward P/E multiples are actually significantly higher than those based on current earnings, which is in line with estimates for little or no growth over the long term.
- Companies like Power-One and PDL BioPharma have speculative levels of risk associated with them, and are therefore priced accordingly despite their promising growth potential.
The thing about all of these companies -- and with most small-caps in general -- is that they aren't really in a position to coast and stay in place. Unlike big-cap stocks in mature markets, in which a large company can maintain a low- or no-growth strategy for decades and still appeal to a subset of conservative investors, small-caps typically either grow to higher status or fade away in importance fairly quickly if they can't make the leap to the next level.
If you're mostly a passive index investor, then you may want to rebalance your portfolio to take advantage of relatively high prices on small-cap stocks. But if you prefer individual stocks, you can still find decent values even as broader indexes hit new records. You just have to be careful not to fall into the many value traps that are more common among small-caps than with bigger companies.
Keep an eye on all seven of these stocks by adding them to your watchlist.
Fool contributor Dan Caplinger loves looking for great value. He doesn't own shares of the companies mentioned in this article. The Fool owns shares of Power-One. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy watches over you.