5 Small-Caps That Could Be Big Performers

 | Jul 10, 2017 | 3:00 PM EDT
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The universe of publicly traded companies in the U.S. stock market is about half what it was 20 years ago -- despite the fact that gross domestic product (GDP) is triple what it was then -- and much of the shrinkage is attributable to the smallest companies, according to data from Credit Suisse.

In May, a Bloomberg article reported that investors had pulled back from small-caps in a big way, more than they had in the 10 years prior and in stark contrast to their post-election surge. As high hopes for corporate tax reduction and the new administration's focus on domestic businesses fizzled, so did the shine on the small-cap penny. The article quoted Andrew Brenner, head of international fixed income for National Alliance Capital Markets: "There's some nervousness out there and people are staying in the most liquid stocks. I think we're getting ready for a much more significant correction."

Does this mean small-cap companies should be overlooked? Not necessarily.

An article posted on ETF Trends last month outlines some advantages associated with small-cap investing:

  • Over long periods, small-caps have outperformed large-caps.
  • Small-caps have a history of recovering quickly after downturns. The article argues that the asset class "bounced back more than twice as fast as large-caps after the tech crash in the early 2000s, and 14 months faster than large-caps following the credit crisis in 2008."
  • Since small-caps are more domestically concentrated, they are less exposed to global events and currency risks.
  • Rising interest rates have less of an impact on small-caps because they typically have lower debt levels than large-caps.

A Nasdaq article from earlier this year makes the case that attractive small-cap stocks can fly under the radar because they are overshadowed by larger household names. "Incredibly, even in our information age," it argues, "small-cap companies still don't get enough coverage compared with their large-cap peers," adding that major developments and/or innovations in the small-cap space can go unnoticed for some time, if not completely. Any development or news item regarding a big tech name, on the other hand, will be featured on countless media outlets. The article also asserts that smaller companies can take advantage of low interest rates to develop "technological breakthroughs" and therefore could become appealing acquisition targets for larger, cash-rich companies.

Clearly, if the new administration's tax reform policies come to fruition, smaller companies are poised to benefit from lower corporate tax rates -- but it remains to be seen if the policies will push through. In the meantime, however, there are opportunities inherent in those small-caps with strong fundamentals -- not just those that fit the bill with respect to market capitalization.

At Validea, our Small Cap Growth portfolio, inspired by a strategy developed by David and Tom Gardner of The Motley Fool, has outperformed the S&P 500 for 12 out of the 15 years since its inception and by a very wide margin. While small-caps have not been performing as well this year, it's important to note that at the end of last year the market had priced in optimism regarding the new administration's pro-domestic policies (perhaps without considering implementation risks). The stock screening models I created based on the investing philosophies of some of Wall Street's most successful gurus, however, take such influences out of the equation and focus on underlying operating fundamentals.

Using these models, I have identified the following high-scoring stocks:

Hudson Technologies (HDSN) is a refrigerant services company that provides products and services used in commercial air conditioning, industrial processing and refrigeration systems (market cap $370 million). The company earns high marks from our Motley Fool-inspired investment strategy based on its trailing 12-month profit margin (after-tax) of 11.56%, which well exceeds the minimum requirement of 7%. This screen also likes the stock's price performance as evidenced by its relative strength of 96 (the model requires a level of 90 or higher to pass). Our Peter Lynch-based screening model favors the exceptionally low leverage (debt-equity of 0.23%), and our Martin Zweig-inspired strategy likes the long-term growth in earnings per share of 20.55% (based on three-, four- and five-year averages), which is well above the minimum requirement of 15%.

Franklin Financial Network (FSB) , through its subsidiary, provides a range of banking and related financial services (market cap of $537 million) and scores well, according to our Lynch-based screening model, due to its favorable ratio of price-earnings to growth in earnings per share (PEG ratio). A company passes this test if the PEG ratio falls below 1, and FSB passes with flying colors with a PEG of 0.59. Our Fool-inspired investment strategy favors the company's after-tax profit margin (trailing 12-month) of 29.17%, which is well above the minimum requirement of 7%. Free cash flow per share of $2.17 adds appeal.

Xenith Bankshares (XBKS) is a holding company for Xenith Bank, a commercial bank specifically targeting the needs of middle-market and small businesses (market cap of $731 million). Our Lynch-inspired investment strategy favors the company's PEG ratio of 0.32, a best-case level as it falls under 0.5. Our Fool-based screening model likes the stock's price performance as evidenced by its relative strength of 90, and operating cash flow of $2.05 per share adds interest.

LeMaitre Vascular (LMAT) is a provider of medical devices for the treatment of peripheral vascular disease (market cap of $590 million). Our Momentum screening model favors the company's quarter-over-quarter growth in earnings per share of 33.33%, well above the minimum requirement of 18%, as well as average annual earnings growth over the past five years of 32.65%. Current share price of $31.39 falls within 15% of the 52-week high, a plus under this model. Our Fool-based investment strategy likes the company's after-tax profit margin (trailing 12-month) of 12.52%, which is well above the minimum requirement of 7%.

Argan (AGX) , through its subsidiaries, provides engineering, construction, maintenance, technical and consulting services to the power generation and renewable energy markets. The company earns a perfect score under our Joel Greenblatt-based screening model based on its earnings yield of 31.13% and return-on-total capital of 43.77%. Together, these metrics place the company 20th among the stocks in the Validea database. Our Lynch-inspired investment strategy favors the PEG ratio of 0.36, which falls in the best-case scenario (under 0.5).

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