Small stocks, big profits

Each December I grade the largest stocks in Canada for the MoneySense Top 200 ranking. But, as a personal project, I’ve also been grading Canada’s smaller stocks at the same time, using the same methodology. The result? Over the past three years the top small stocks have actually done better than their larger counterparts in the Top 200.

In 2004 the top small stocks gained 54.8%. In 2005 the tiny superstars climbed 44.6%. In 2006 the pint-sized overachievers advanced a further 18.3%. If you had bought the top-rated top small stocks in 2004 and rolled your gains into the new bunch each subsequent year, you would now be up 170%, not including dividends. That compares to a gain of about 152% for the top-rated stocks in the Top 200.

I hope that my smaller stocks continue their hot streak, but I would urge you to be cautious. Small stocks are prone to big swings and tend to be riskier than larger stocks. You should limit them to a modest portion of your portfolio. Still, if you’re looking to add some spice to your portfolio, I think small stocks are definitely worth a look. They can grow far more rapidly than big firms if the conditions are right. And they frequently represent better value than their larger competitors.

The key is to do your homework before buying. I grade small stocks using exactly the same methodology as I do with large stocks. Each stock gets two letter grades—one for its growth prospects, the other for its value appeal. The grades run from A (for top-of-the-class superstars) to F (for struggling underachievers). I’m particularly interested in stocks that manage to earn an A or a B for both value and growth.

Some extraordinary qualities are needed to get high marks. On the value front, I look for stocks that pay dividends and that sell at low prices compared to their book values. They have to generate at least some earnings and they can’t carry much debt. On the growth side, I seek stocks that have achieved strong growth in sales and earnings over the past five years. Top-rated growth stocks also have to demonstrate healthy returns on equity, strong momentum, and reasonable price-to-sales ratios. (You can find a detailed explanation of the methodology, and a complete ranking of the best large stocks in Canada, in the December/January issue of MoneySense.)

From hundreds of small stocks, I’ve selected a few that score particularly well on both value and growth. You should, of course, do your own research before adding any of them to your portfolio. Here’s why they’re worth a look:

Akita Drilling (AKT.A, $11.22) is an oil and gas drilling and servicing contractor with operations in western Canada and Alaska. This year, it’s my highest rated small stock, earning an A for value and a B for growth. Akita’s only blemish is a little recent weakness in its share price. But that means that you can buy Akita at just above its book value and for only nine times its earnings. You get a 2.5% dividend yield in the bargain.

Clarke (CKI, $7.66) is a Halifax holding company controlled by George Armoyan, the famed value investor. He’s been very successful at buying into depressed firms, shaking them up and unlocking shareholder value. If you like Armoyan’s style, and want a convenient one-stop way to buy into a diversified portfolio of small stocks and trusts, Clarke is a tempting proposition.

H. Paulin & Co. (PAP.A, $8.50) keeps its eye on the nuts and bolts—literally. It describes itself as being the “first in fasteners” and is also active in fluid systems and auto parts. Based in Toronto, Paulin has faced some mighty challenges from the rising loonie and declining automakers. But it has still managed to grow its sales and profits, and trades at only 51% of book value.

Brampton Brick (BBL.A, $10.60) is Canada’s second largest producer of clay bricks; it also makes paving stones and other landscape products. The Brampton, Ont., firm sells to both Canadian and U.S. customers and has been hard hit by the recent collapse in the U.S. housing market. Still, it could be a bargain: it trades below book value and pays a nice 1.9% dividend.

Amerigo Resources (ARG, $2.34) is headquartered in Vancouver, but makes its money by extracting copper and molybdenum from the tailings of the world’s largest underground copper mine in Chile. I like the company’s low debt levels, generous 16.6% earnings yield, and 5.6% dividend yield. Given the unpredictability of metal prices, Amerigo is likely to be a wild ride, but if you’re willing to take a flyer, it’s an interesting speculation.