The best small cap stocks

After suffering through a cold winter it’s hard to believe that spring is right around the corner. I’m always amazed by how fast my neighbourhood goes from being enveloped in snow to breaking forth in a riot of colour. Grand old trees extend their leaves and grow a little bit each year while new seedlings race quickly toward the sky.

In a similar way, mature companies are usually the slow growers of the business world while some of today’s small firms will shoot up rapidly to become the giants of tomorrow.

The propensity for small stocks to grow faster than large stocks drives their relative returns. In one study, Dartmouth professor Kenneth French sorted U.S. stocks into three groups by market capitalization (a stock’s price times its share count). Each group was tracked for a year and then the process was repeated. As a result, he was able to figure how small, medium and large stocks fared over the long-term.

The smallest 30% of stocks did the best, with average gains of 12.1% per year from 1960 through to the start of 2015. The middle group did nearly as well with annual returns of 12.0%. However, the largest 30% of stocks lagged behind with gains of only 9.9% annually. You can examine the return history of each group in “It pays to think small,” which you’ll find to the right.

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Professor French’s research prompted us to search for small stocks that pass the value and growth tests we employ each year in the MoneySense Top 500 ranking of large U.S. stocks.

Alas, in a reversal of fortune, small stocks lagged big stocks in the U.S. since we started rating them a year ago. The S&P 500 index of large stocks gained 16.5% since last time while the Russell 2000 index, which tracks smaller stocks, climbed 7.2%. The small stocks that made it into our All-Star list last year (by earning two As or at least one A and one B for their appeal as value and growth investments) advanced only 4.7%.

While last year’s Small Cap All-Stars didn’t beat the market, we’ve been through many ups and downs in the past and still believe our approach will do well over the long-term.

That’s why we’re pleased to present you with our second annual Small Cap 100 report. In it we evaluate 1,000 stocks for their appeal as value investments and growth investments, using the same methodology as our annual Top 500 ranking. But this time the focus is on smaller firms with market capitalizations ranging from roughly $200 million to just over $2 billion. (All figures in U.S. dollars.)

We decided to stick to U.S. stocks for a couple of reasons. First, the Canadian small-cap market is dominated by energy and mining companies, which tend to be highly volatile. Second, the selection of stocks is much larger south of the border.

While we like small stocks, some tiny firms can cause problems. For instance, some of them trade infrequently and they can suffer from other peculiarities. It’s why we start with stocks that have market capitalizations and revenues of more than $200 million. That might sound like a big amount, but it’s quite small compared to a big company like Apple (AAPL), which earns about $120 million every day.

We then grade the next 1,000 companies above our limit (when ranked by market cap) using data from Bloomberg. The smallest stock we looked at this time was Inventure Foods (SNAK), which has a market capitalization of just over $200 million. The largest was DigitalGlobe (DGI), with a market capitalization of a little more than $2.2 billion. If our suspicions are correct, you probably haven’t heard of either one.

Making the grade

Every stock is first evaluated for its growth potential. Those with the best records are awarded As, the next best get Bs, and so on, all the way down to Fs for those in need of improvement. Then every stock is graded based on its appeal as a value investment. The best deals get As while firms that trade at lofty prices take home Fs.

To get top marks each stock must pass a series of strict tests. On the growth side, we favour firms that have increased their sales per share and earnings per share at a good clip. We also like strong returns on equity, healthy market performance over the last year, and low-to-moderate price-to-sales ratios. On the value front, we appreciate stocks selling at modest price-to-book value ratios compared to their peers and to the markets overall. We view high debt loads negatively and give extra points to profitable ventures that pay dividends. To get to the very top of the class, a stock should ideally possess all of these qualities.

The very best prospects get a coveted double-A rating, which makes them outstanding growth and value candidates. Five stocks earned the double-A award this time around. But we believe all of the 61 All-Star stocks that managed to get at least one A and one B are well worth consideration.

Before you load up on small stocks, keep in mind that they can be risky. While we think our Small Cap All-Stars have what it takes to be successful, the future is far from certain and some of them will disappoint. That’s why it’s best to build a broadly diversified portfolio that balances small stocks with less volatile holdings like larger stocks, bonds and other assets.

Our guide is a great place to start your search for interesting candidates and it contains a wealth of information to help you on your way. The 100 stocks with the highest grades are displayed in the tables on the following pages. We have marked each of the 61 Small Cap All-Star stocks with a red star. In addition, because of its huge size, we posted a link to download the full 1,000-stock table, it’s free for subscribers.

Remember that stock screens have their limitations. Before you invest, make sure a company’s situation hasn’t changed in some important way. Read its latest press releases, regulatory filings, and scan newspaper stories to get up to speed on all the most recent developments. As always, we endeavour to put you on the path to a profitable future. But you should head to the market only after you’ve done your homework.

It pays to think small

Small stocks have historically outperformed their larger brothers, despite the many ups and downs along the way. From 1960 through 2014, small-cap U.S. stocks returned 12.1% annually, compared with 12.0% for mid-caps, and 9.9% for large stocks.

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The mid cap all-stars

Mid-cap stocks have gained more than large stocks over the long term and they’re generally able to weather economic shocks better than smaller firms. That’s why many investors like to look for bargain stocks with market capitalization between $2 billion and $10 billion. The 10 U.S. stocks listed alphabetically in the table to the right were too large to make it onto our Small Cap 100 list, but we think they offer similar potential. These mid-caps got at least one A and one B according to the value and growth tests we used for our small-cap stocks. In an effort to encourage diversification, each one is from a different industry group ranging from electronics to apparel and insurance.

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NON-SUBSCRIBERS: Download the Small Cap 1,000 Package for $9.95 »

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Norm Rothery, CFA, PhD, is the founder of StingyInvestor.com. He may own shares of the Small Cap 100 stocks.