The Keys to Uncovering Superior Small Stocks

I look for two types of stocks -- deep value and earnings power staircases.

Deep-value stocks sell for 0.5 times sales, five to seven times defensive profits (free cash flow), and one times book value (corporate net worth). As a rule, companies of this ilk have problems -- otherwise, they wouldn't be priced so cheap.

That's fine, provided the financial risk is nil. With these statistically cheap issues, I'm looking for a catalyst such as new management or a rising operating profit margin to cause the market to reconsider the firm's prospects, and let me double my money in four to five years.

What interests me the most, however, are earnings power staircase companies, or staircases for short. A staircase combines safety characteristics with the potential for big capital gains.

Related Stories

Worry About the Quality of EDS' Earnings, Too

Working Out the Details With Microsoft

To qualify, a company must meet two conditions. First, it is situated in the upper-right box, or Earnings Power Box, of an x-y scatter chart, and second, it keeps moving in an upper-right direction.

With a staircase, I'm looking for a fivefold return in 10 years, which works out to an 18% compound annual growth rate, excluding any benefit from reinvested dividends. (To learn why staircases are better than plain old growth companies, please read an earlier column on Enron.)

Paychex (PAYX - commentary - Cramer's Take) is a staircase. During the 1990s the payroll services provider was situated in the Earnings Power Box and also kept moving in an upper-right direction. A $10,000 investment made at the beginning of 1990 was worth $350,000 at the end of 1999.

Source: Company reports; EarningsPower.com

So how do you find your own staircase for the next 10 years?

---

Hewitt Heiserman has been a financial analyst for 15 years and has worked for Fidelity Investments, Simplex Time Recorder, American Holdco and Breakaway Solutions. He is now writing a book on the Earnings Power Box, an analytical model he created to gauge the quality of a firm's profits. (The Earnings Power Box is a trademark of Hewitt Heiserman.) At the time of publication, Heiserman had no positions in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback and invites you to send it to [e-mail].