The Keys to Uncovering Superior Small Stocks

One treasure trove of potential buys is the annual Forbes 200 Best Small Companies issue. But be careful. In last year's issue, Measurement Specialties (MSS - commentary - Cramer's Take) looked like the next big thing, as accrual profits for the three years ended March 2001 compounded at 126% annually. Forbes had this maker of sensors and sensor-based products ranked No. 3 on its list.

Crucially, as we see below, Measurement's defensive profits were turning sharply negative while accrual and enterprising profits were on the upswing. As this column has noted before, triple-check your assumptions when you see this type of divergence.

In Measurement's case, defensive losses were due to a burdensome investment rate in working capital.

Measurement Specialties Investment Capital

*Dollar amounts in thousands

For fiscal 2001, Measurement invested 48 cents of every dollar of incremental revenue in higher net working capital, principally inventory. That's a lot, because every dollar invested in inventory is a dollar less to pay down debt, repurchase stock, or invest in growth-producing intangibles like research and development or a new marketing campaign. Also, changing consumer preferences and rapid technology changes can quickly render inventory worthless.

Because of its sizeable investment in working capital, Measurement fell from the Earnings Power Box to the lower-right box despite the robust gains in accrual profits. I don't buy companies headed in this direction unless they are deep-value stocks, and Measurement was no deep value.

Source: Company reports; EarningsPower.com

By the way, shortly after Forbes' 2001 list hit newsstands, Measurement developed acute financial difficulties and trading was halted. The stock, which sold as high as $25 in early 2001, reopened last week after a long hiatus at about $2.

Now, let's scrub the numbers for Chico's FAS (CHS - commentary - Cramer's Take), Forbes' top-ranked company in its current Best Small Companies issue. Recently, this retailer of casual-to-dressy clothing for women over age 30 had a $1.7 billion market value.

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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].