Small Caps, Big Opportunities

 | Nov 21, 2013 | 12:30 PM EST
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There's no question the stock market has done well this year. The S&P 500, which is of course made up of large-cap stocks, is up 25%. Sounds good. But a segment of the overall market is doing even better. As measured by the Russell 2000, small-caps have levitated 30% this year.

Small-cap companies tend to be more volatile than larger-cap ones and also tend to provide higher returns, which is why you need small-caps in your portfolio. From 1926 through 2012, small-cap average annual return was 11.9% vs. 9.8% for large-caps, according to Morningstar Ibbotson as reported by Bankrate. This makes sense since large-aps can only grow so large, while small-caps have much more room to grow.

The market caps of Russell 2000 companies range from $129 million to $3.3 billion. Others limit the market cap of small companies to $2 billion. Since we at Real Money require a minimum market cap of $500 million, I screened for stocks whose market caps were between $500 million and $2 billion and which earned a high grade from one of my guru strategies. These are computerized strategies I created by mirroring the investment techniques of Wall Street's greatest thinkers and investors. A company that's a small-cap and has guru approval has two strong factors in its favor.

One such company is the national pizza chain Papa John's International (PZZA). My James P. O'Shaughnessy-based strategy likes the company's market cap ($1.76 billion), earnings per share, which have increased in each of the past five years, and price-to-sales ratio of 1.26 (1.5 is the maximum allowed). This last variable identifies growth stocks that are still cheap to buy. The final variable used by the strategy is relative strength, which is a measure of how well a stock has performed during the past year relative to the market. Among the companies that pass the first three criteria, the strategy picks the top 50 based on relative strength. With an 81 relative strength rating, Papa John's finds itself in this top-50 group of stocks.

Ebix (EBIX), whose market cap is $528 million, provides software systems for the insurance industry, while operating in more than 50 countries. The strategy I created from the writings of Joel Greenblatt likes this company. The strategy looks at earnings yield and ranks a company based on this variable from all the thousands of stocks in our database. Ebix ranks 55 for this variable. The strategy then ranks the company based on return on total capital, with Ebix's ranking being 20. Then the strategy takes these two variables and creates a final ranking and, based on this, Ebix ranks an impressive 4.

Another small-cap to consider is Select Comfort (SCSS), which has a market cap of $1.09 billion. The company manufactures and markets beds known for their ability to be adjusted for firmness. The products are sold under the Sleep Number brand through approximately 400 company-owned stores across the U.S. This stock is praised by my Peter Lynch-modeled strategy, which focuses on the P/E/G ratio. This is price-to-earnings relative to growth and is a measure of how much the investor is paying for growth. Select Comfort's P/E/G is 0.83, nicely below the 1.0 maximum allowed. Another plus is that the company has no debt.

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I reached out last week to my close friend Ken Shreve, who is a prominent writer for the IBD.  I asked Ke...
I reached out last week to my close friend Ken Shreve, who is a prominent writer for the IBD.  I asked Ke...
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