Big Upside in Small-Caps

I'm a big fan of small-cap stocks -- always have been, always will be. While this area of the market can bring with it additional risk compared to large-caps, it can also bring opportunity.

Small-caps are sometimes underfollowed relative to their larger cousins, and the market tends to be more inefficient. Typically, you don't have an army of analysts following many of these companies, so they don't tend to be picked over the way many larger companies may be. Inefficiency in this case is a positive term; it simply means that investors have greater opportunity to identify mispriced securities.

And we are in a great environment for mispricings. Given the amazing volatility we are currently experiencing in the markets -- i.e., the roller-coaster ride of ups and downs -- I think we'll look back in a couple of years and marvel at the tremendous bargains of 2008.

To that end, I recently screened for smaller companies meeting the following criteria:

• Market cap between $500 million and $2 billion (to identify smaller companies)
• Current price-to-earnings ratios of less than 15 (this is a more value-oriented search)
• Forward P/E of at least 20% below current P/E (to identify companies whose earnings are expected to rise)
• Forward P/E below company's five-year average P/E
• Total debt to equity less than 30% (too much debt can be devastating; we want companies without a huge anchor)
• Any sector except energy and financials (I still don't trust the financials, and I don't believe current estimates have enough visibility)

Just 10 companies met the screening criteria:

Company	Ticker	Industry	Current P/E	Forward P/E	Five-Year Average P/E	Market Cap ($billion)	Price
Integrated Device	IDTI	Semicon	14.9	11.2	60.0	1.92	11.27
Tech Data Corp.	TECD	Tech Dist	15.0	11.7	20.0	1.91	35.94
Vishay Intertech	VSH	Electronic Components	11.5	9.1	32.0	1.85	10.19
Benchmark Electronics	BHE	Electronic Components	13.8	10.7	18.5	1.13	17.16
Teletech Holdings	TTEC	Comm Svcs	14.1	11.7	32.8	1.12	15.86
Gymboree	GYMB	Apparel	12.9	10.5	19.5	1.08	28.35
Callaway Golf	ELY	Golf Clubs	13.6	11.3	14.2	0.918	37.31
United Online	UNTD	Web Portals	12.2	10.0	14.9	0.774	11.56
Omnivision Tech	OVTI	Electronic Components	10.6	8.8	19.0	0.631	11.7
Netgear	NTGR	Networking Products	11.7	9.0	25.0	0.586	16.7
Source: Bloomberg

Here are a couple of highlights:

Gymboree (GYMB Quote - Cramer on GYMB - Stock Picks): This children's-clothing maker has a strong brand name to go with a solid balance sheet. Sales for the first quarter were up 16%, while earnings grew 20%. The company seems immune to the slower economy. Shares are up 23% year to date but still trade at just 10.5 times fiscal 2010 earnings, and well below the five-year average of 19.5. Profit margins also continue to increase; this past quarter the company netted 10.34%.

There still may be a growth story here as well, as Gymboree's estimated long-term growth rate is 11.67%. Given the company's low P/E and PEG ratio of just over 1, Gymboree shares are cheap at current levels.

Callaway Golf (ELY Quote - Cramer on ELY - Stock Picks) -- This former growth darling looks interesting here. The company continues to generate solid earnings and margins, even through the first half of 2008, in what should be a difficult environment for the discretionary products (golf clubs) that Callaway manufactures and sells. Second-quarter sales were down 3.7% sequentially, but net income was still up slightly. The company has also been buying back stock and currently yields 2%. Shares currently trade at just over 11 times next year's earnings, and well below the five-year average P/E.

Callaway also has decent growth prospects, with an estimated long-term growth rate of 12.71%. The company's PEG ratio is just 1.05, low enough to warm a value investor's heart.

You obviously need to do your own research to find suitable additions to your portfolio, but the small-cap world is offering great bargains here -- don't pass them up.