Alan Brochstein shares some pointers and uncovers 2 potential prospects
Recently I made the case that investors should make an effort to uncover smaller companies, despite the likelihood that it won’t be as easy to beat the S&P 500 just by betting on the whole group of Small-Caps (For Bigger Gains, Think Smaller (Companies)). While we aren’t experiencing the tailwinds of the past few years, I don’t see any headwinds either. With that in mind, it can pay to search for stocks off the beaten path. Today's post offers some additional thoughts about how to find those potential opportunities.
Let’s make sure we are all on the same page. First, what exactly is a “small-cap”? Different people will give different answers, but I tend to think of the term as applying to companies with market capitalizations (number of shares times price per share) ranging from $200mm to $1 billion. Smaller companies are considered “micro-cap”, while larger ones are considered “mid-cap”. The S&P 600 Small-Cap Index, which is monitored by Standard & Poors and kept current through additions and deletions on a continuous basis, currently has an average market cap of $868mm, with a range of $77mm to $3.5 billion. If we strip out the top and bottom 10%, the range is $270mm to $1.7 billion, so my definition is in the ballpark, though maybe a bit low.
When I'm looking at smaller companies, I look for many of the same qualities I like to see in larger companies:
• Reasonable or Cheap Valuation
• Positive Price Momentum (or extreme negative momentum or oversold)
• Stable/Rising Earnings Estimates
• Strong Balance Sheet
• History of Strong Sales Growth
Some additional things I look for include somewhat limited coverage by Wall Street and high inside ownership. When a company isn’t so widely followed, it’s often not hyped, though this isn’t always the case. I tend to be contrarian: when everyone is saying how great a stock is, the positive sentiment is likely reflected already in the price. Inside ownership is the small investor’s friend, as it allows us to invest alongside the person running the company. This can be tricky, as sometimes too much ownership (majority) can lead to a dent in that potential strong alignment. After all, someone who controls the company almost exclusively may tolerate a “heads I win, tails you lose” situation, paying himself exorbitantly, engaging in nepotism or many other actions that would be contrary to other investors' interests.
Here's a screen designed to uncover small companies with all of the favorable attributes I cited above. My screener doesn’t include any stats on inside ownership, so I have to take the results from the other factors and then find that information myself. (It's listed in the Definitive Proxy Statement or Schedule 14A that is filed with the SEC on an annual basis). Here's the screening criteria I used:
• Universe: Russell 2000
• Market Cap: $200mm-$1 billion
• Sales growth: 5yr > 15%, 1yr > 8%
• Trailing PE < 24
• Earnings Estimates for 2011: No negative revisions over past 12 weeks (for companies with coverage)
• Analyst Coverage:
• Net Debt to Capital < 10%
• 3-month Price Return > S&P 500
• Insider ownership: 10-40%
Here is what we get:
We started with about 2000 stocks and ended up with only five. Of those 5, two had less than 10% ownership, while one was greater than 50%. The remaining two stocks, both technology companies, have 12.5% inside ownership for Oplink Communication (OPLK)
and 35.8% for Super Micro Computer (SMCI)
Now, before you go put your buy order in, keep in mind that this was just a demonstration. I am not familiar with either of these companies, but this is how I find ideas to investigate further. In these cases, there are several positive factors that capture my attention, leading me to believe that it might be worth it to do the extra research. These are companies that are growing strongly, have reasonable valuations (12-13 P/E on a forward basis), performing well, debt-free, not widely covered by Wall Street, enjoying upward revisions to earnings estimates (I omitted that from the table, but both have seen estimates rise sharply recently), with shares owned substantially by executives and directors. It’s not enough, but it’s a great start!
Hopefully I have given you a few ideas about how to investigate smaller stocks. I encourage you to learn about screening criteria that are important to you and to use them to narrow down what can be an overwhelming universe of stocks. Maybe you can uncover a gem! Remember, screening is a starting point as part of a more thorough investment process.
Disclosure: Alan currently holds no positions in the securities mentioned in this post.
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